On central banks and the financial crisis


The last Jackson Hole symposium produced some interesting papers. Foremost was the Mishkin paper that set out how the Bernanke Fed would act in the face of the financial crisis, and the Taylor paper that blamed the crisis on Greenspan keeping interest rates too low (As Soros suggests in his book, this was to get W re-elected, a suggestion conspicuous by its absence in Greenspan’s own book.)

Mishkin’s position was the same as Greenspan’s. If it is not possible for the market players to recognize a bubble, it would be impossible for any central bank, including the Fed. So, Fed policy cannot be changed to prick asset price bubbles which may develop over a long period. However, since asset price busts can happen very swiftly and create problems in the real economy (cause a recession), the Fed must cut interest rates swiftly and provide sufficient liquidity to forestall any problems in the real economy.

Taylor’s paper simply said that the Fed deviated from its usual interest rate setting rule in 2002-2004, keeping interest rates too low, even while the economy was improving. This is what led to the housing bubble in the first place.

Both Taylor and Mishkin could not possibly be right. If Taylor was right, then Mishkin and Bernanke were trying to solve a problem (housing bubble) caused by low interest rates by ahem, lowering interest rates swiftly. One year later, it is evident to everyone that things haven’t quite panned out as Mishkin may have expected.

In the current Jackson Hole meet, Willem Buiter presented the case against the central banks’ handling of the crisis, particularly that of the Fed. The paper is far too long, but quite amusing, as is Alan Blinder’s reply to it.  Focusing on the three central banks, The Fed, the ECB and the BoE, he says that while the Fed did well to contain the current crisis, it has definitely failed in preventing future crises (the same point that John Taylor made last year), and handed the wooden spoon for handling the current crisis to the BoE.

Dave Altig ponders over the symposium in a very good summary. According to Dave, the best paper at the Symposium was presented by Anil Kashyap and Raghuram Rajan along with Jerome Stein, who proposed an insurance policy that would infuse the banking system with capital when it needs it the most (like now). Somehow, it seems a bit like closing the barn door after the horse has bolted. To his credit, apparently Rajan proposed the same thing three years ago, and was told off by “women have no brains” Larry Summers.

I wonder why the experience of another developed country, with a recent housing boom bigger than the US, but one that benefited from prudent central banking was not considered. I guess it was, in a small footnote on page 24 in the Rajan paper.

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