September 09, 2003

A Year Ago Today: Stephen Roach on the Great Failure of Central Banking

From the archives. I still disagree, but I think Roach puts the case very strongly:

Stephen Roach on "The Great Failure of Central Banking": Archive Entry From Brad DeLong's Webjournal: I don't agree with Stephen Roach that the Federal Reserve should have made interest rates higher and tried to make unemployment higher in the late 1990s in order to diminish investment spending and collapse the stock market bubble. In my view, the time to deal with any problems created by the bubble's collapse is when the bubble collapses--not before. Relative to a lower-stock prices, lower-investment, one-percentage-point-of-unemployment-higher bubble-popping path for the U.S. economy in the late 1990s, the actual path that we took gave us an extra $1 trillion of real production.

You can complain about how that $1 trillion was distributed. You can regret that a large chunk of it--$200 billion?--was spent on investments that have much lower social value looking forward than their social cost. You can fear the damaging consequences of banruptcy and fraud on the economy. But you have to argue that these drawbacks from the fallout are quantitatively very large for the cost-benefit analysis to go Stephen Roach's way.

Nevertheless, he makes his case more strongly than anybody else does:


Morgan Stanley: ... Yet out of this glorious disinflation a new inflation was borne -- asset inflation. And central bankers didn’t have a clue how to deal with it.

They still don’t. The Bank of Japan was the first victim of the new inflation. Asset bubbles in equity and property markets in the late 1980s created enormous excesses in Japan’s real economy and in its financial system. The history of Japan’s pre- and post-bubble period tells us that the BOJ was late in recognizing the perils of what was to come. Its monetary policy stance was too accommodative in the late 1980s, thereby nurturing the build-up of the bubble. And it was too restrictive in the early 1990s, failing to appreciate the deflationary risks that always get unleashed in the aftermath of a popped asset bubble. Some 13 years after its bubble crested in 1989, Japan is still picking up the pieces. An alternative approach by the BOJ could have made a real difference.

It’s different in America -- I guess it always is. But the similarities with Japan should not be ignored. America’s asset bubble created its own set of distortions in the real economy. Capital spending went to excess as Corporate America became convinced it could acquire Nasdaq-like multiples through open-ended investment in new information technologies. Remember the e-based IT spending frenzies associated with B2B and B2C? The Y2K panic was the icing on this rapidly rising cake. Consumers also got lured into the bubble, increasingly viewing outsized equity returns as permanent substitutes for saving the old-fashioned way -- out of their paychecks. By the end, the very fabric of the US economy had been transformed -- the bubble had become the heart of the New Economy.

Like the BOJ, the Fed did nothing to stop it. Sure, there was the December 1996 musing by Alan Greenspan over "irrational exuberance." There was even a 25 bp tightening some three and a half months later, presumably aimed at addressing those concerns. But that assault on the bubble -- if you want to call it that -- was short-lived. Facing a torrent of political criticism for tampering with the democracy of the markets, the so-called independent US central bank did an about-face. Any further tightening was shelved, and the bubble took on a life of its own...

Posted by DeLong at September 9, 2003 12:01 AM | TrackBack

Comments

Does your disagreement go beyond that there would have been lower production? What would the inflation rate have been by the year 2001 if the Fed's goal was to limit asset prices and not keep inflation in a range? For all this irresponsibility and wealth effect the core rate only rose to about 2.5% before falling.

I don't at all understand why anyone would want to include asset prices as part of inflation. To me the rise in paper assets signifies that there are somewhere people with buying power that don't feel like using it and are trying ineffectively to hold it for later. That their effort is ineffective isn't the Fed's fault since there is really no way for everyone to delay their purchases. The situation is quite the opposite of goods and services inflation where everyone wants to consume more than is produced. So why is it bad that interest rates fall, causing assets to rise and limit future gains of saving, and causing incentives to consume savings?

Sure this all could reverse and cause goods and services inflation in the future, but that could be many years down the road. When that happens the Fed will work in the other direction. But I just don't see how Fed policy can be based on potential inflation when there is plenty of capacity to produce things now.

"Nevertheless, he makes his case more strongly than anybody else does"

I know he definitely makes it more frequently.

Posted by: snsterling on September 8, 2003 11:41 PM

This reminds me of an old controversy about the causes of the Great Depression. At the time many conservative economists held the view that the stock market boom was the result of loose fed monetary policy in the 1920s, which reflected itself not in goods-price inflation but in asset-price inflation. Nowadays such views are held mainly by latterday Austrians, not “mainstream” economists, even conservatives ones (The monetarist school specifically rejected that view of 1920s monetary policy). Nonetheless, the 1990s boom/bust seems to give new credibility to old fashioned “over-investment” theories of the business cycle. The views of Roach that you quote seems to be similar to those old-fashioned theories about the Depression. As a non-economist, the question I have is, what kind of empirical evidence would resolve this kind of controversy?

Posted by: Phil P on September 9, 2003 06:39 AM

"Facing a torrent of political criticism for tampering with the democracy of the markets, the so-called independent US central bank did an about-face." Did the Fed act as it did because of political pressure or did it have concerns of its own?

I've been under the impression that the Fed's reaction to the Asian meltdown was the cause of the asset bubble. I fail to see the downside in that tradeoff however. Why is it better to allow financial meltdowns to roil markets and restrict investment than to encourage more investment than may be needed in the short term?

Posted by: Stan on September 9, 2003 07:51 AM

Mr. Roach's case is, I believe, that speculation has taken the place of traditional savings and created asset inflation. Even worse, the easy credit policies of the Fed have encouraged people to borrow money with which to speculate. This ultimately results in misallocation of resources and excess capacity.

Posted by: Kosh on September 9, 2003 07:55 AM

snsterling wrote, "I don't at all understand why anyone would want to include asset prices as part of inflation. To me the rise in paper assets signifies that there are somewhere people with buying power that don't feel like using it and are trying ineffectively to hold it for later."

The reason is that speculative bubbles are very damaging. First, they lead to misallocation of resources, which is the result of distorted price signals. (A good example was the overinvestment in fiber optic capacity in the mid/late 1990s.) Second, when they burst, the effects are painful.

It's not clear that asset inflation is merely the product of people wanting to hold assets instead of purchasing goods or services. Take the stock boom---presumably, people could have purchased *different* assets. The problem with the stock boom is that asset prices were, in terms of the long term, severely distorted. (Think AOL, for example.)

Stan wrote, "I've been under the impression that the Fed's reaction to the Asian meltdown was the cause of the asset bubble. I fail to see the downside in that tradeoff however. Why is it better to allow financial meltdowns to roil markets and restrict investment than to encourage more investment than may be needed in the short term?" I kind of agree with that. However, I thought it also had to do with Greenspan bailing out the banks in the early 1990s (though I suppose arguments can be made in favor of that, too). And IIRC Greenspan had other mechanisms at his disposal to take some air out of the bubble, namely (a) jawboning (he did the opposite with his talk of a new era productivity revolution) and (b) raising amount you have to put down to buy stocks on margin.

Posted by: Stephen J Fromm on September 9, 2003 08:36 AM

Upon closer inspection, I just restated Kosh's claim in a long-winded fashion.

Posted by: Stephen J Fromm on September 9, 2003 08:43 AM

"(A good example was the overinvestment in fiber optic capacity in the mid/late 1990s.)"
"Take the stock boom---presumably, people could have purchased *different* assets. The problem with the stock boom is that asset prices were, in terms of the long term, severely distorted. (Think AOL, for example.)"


Stephen,

But then you're talking about relative prices of assets and not just asset prices in general. To what extent is it the Fed's job to undertake a study of Dense Wave Division Multiplexing and conclude that we were in a new era where exponential growth in communications demand could be met without exponential growth in fiber? (Actually, I had a relative involved in the fiber business and when he told me about these new multiplexers and the technology curve they were on I saw right away what would happen.)

Anyway, since you are suggesting that other assets were being shunned (possibly certain out of fashion sectors of the stock market, real estate, or domestic and foreign bonds, etc...), what responsibility does the Fed have to come out and comment on relative asset prices.... for example, should Alan Greenspan have said AOL is overvalued and suggest some other investments? Should he have warned that the Pets.com business model is flawed (though there are many online pet stores now)?

I do understand and agree with you that jawboning can help prevent a mania in a particular sector. But it does pit the investment judgement of a few people in Washington against the judgement of seasoned executives and all those who normally evaluate their sales pitches. Perhaps it would be better for the Fed to work to ensure the mechanisms of investment are free of conflicts of interest and then just leave it to everyone else to figure out the truth.... maybe giving vague words of wisdom along the way.

Posted by: snsterling on September 9, 2003 09:59 AM

Mr Sterling

Your comment "I don't at all understand why anyone would want to include asset prices as part of inflation. To me the rise in paper assets signifies that there are somewhere people with buying power that don't feel like using it and are trying ineffectively to hold it for later"

What about the possibility that they use their inflated asset prices to borrow more? Doesnt inflated asset prices result in more borrowing power? And isn't more borrowing power the same as more money?

Posted by: David on September 9, 2003 10:51 AM

Stephen, Greenspan did warn investors of their irrational exuberance. He also acknowledged very real changes afoot in productivity.

Posted by: Stan on September 9, 2003 11:50 AM

Roach is dead wrong. Why damage the rest of the economy because of a stock market investment bubble? When AG raised interest rates too rapidly at the end of the 90s, it did damage the rest of the economy.

People were gambling instead of making wise investments. Brokers were exposing their funds to too much risk. The central bank really cannot get involved. There was a lot of gaming the system such as the IPO ripoffs that were a concern that the SEC should have addressed not the Fed. The problem was the SEC not being allowed to do its job by Congress, not the lack of Fed intervention. To complain that the Fed did not use a sledge hammer to solve a problem that required SEC finesse is overkill.

Posted by: bakho on September 9, 2003 12:57 PM

Of course, Mr. Roach was not calling for more SEC action to stem the stock market bubble, was he?

Posted by: bakho on September 9, 2003 12:58 PM

Some would argue that we are in a new stock bubble with P?E ratios at historical highs. I don't hear Mr Roach calling for AG to raise interest rates to attack the new bubble. Does anyone think this would be a good idea?

Posted by: bakho on September 9, 2003 01:01 PM

snsterling asks:

"To what extent is it the Fed's job to undertake a study of Dense Wave Division Multiplexing and conclude that we were in a new era where exponential growth in communications demand could be met without exponential growth in fiber?"

Correct, this is not the Fed's job. The problem is that the Fed created distortions in the market that made overinvestment in some sectors appear profitable.

Artificially low borrowing costs made it appear attractive to lay miles of fiber optic cable that will not be used for the forseeable future. The lost opportunity cost is the labor and other productive assets wasted which could have been employed productively elsewhere. The some artificially low interest rates which made it attractive for both corporations and consumers to rack up record levels of deb.

This is precisely Mr. Roach's point: Fed meddling in the markets has produced economic distortions which it will take a long and painful process to work off.

Posted by: Kosh on September 9, 2003 01:06 PM

snsterling asks:

"To what extent is it the Fed's job to undertake a study of Dense Wave Division Multiplexing and conclude that we were in a new era where exponential growth in communications demand could be met without exponential growth in fiber?"

Correct, this is not the Fed's job. The problem is that the Fed created distortions in the market that made overinvestment in some sectors appear profitable.

Artificially low borrowing costs made it appear attractive to lay miles of fiber optic cable that will not be used for the forseeable future. The lost opportunity cost is the labor and other productive assets wasted which could have been employed productively elsewhere. The some artificially low interest rates which made it attractive for both corporations and consumers to rack up record levels of debt.

This is precisely Mr. Roach's point: Fed meddling in the markets has produced economic distortions which it will take a long and painful process to work off.

Posted by: Kosh on September 9, 2003 01:07 PM

The smart money on the fiber optics were people like GHW Bush who got cut in on the IPO and lent his name and credibility to Global Crossing, then sold out his shares for a tidy profit leaving the suckers to buy high and sell low. What did the Fed policy have to do with the IPO and stock sales that raised the money for these adventures? Why are you not arguing now that too low interest rates are creating a housing price bubble? Roach is just wrong. Fed policy affects the whole economy. The Fed cannot be a cavalry that destroys the whole tribe if one sector leaves the reservation.

Too many analysts had too little understanding of the technical issues to make a sound judgement on the prospects for the companies they were promoting. This is not a Fed problem.

Posted by: bakho on September 9, 2003 06:56 PM

Bahko and Kosh are both incorrect. The Fed's abilty to leave rates low and accomodate the bubble is enormously different than in Japan: our corporate markets are much more highly evolved and more resilient where we have transparent ratings, speedy bankruptcy process. The SEC does not have powers to intervene on the scale presumed: even strictest scrutiny would have changed little where fraud can take years to uncover.

DeLong is perhaps a bit naive to think that $ measures subsitute for numbers of years to work down excess capacity or obsolete asset valuations: the $200 bn # is more like $.5 trill.

Roach is paid to write for what, comparatively, amounts to a dumbed-down audience obsessed with inflating 5-year forward projections even further than already extrapolated: he has to demonstrate a simple Japan analogy where his own views are far more complex. He serves an important function in reminding capital markets slaves of asset inflation perils. The "saving the old-fashioned way" reminder is a good one.

Posted by: Faith W. on September 9, 2003 09:26 PM

bakho asks:

"Why are you not arguing now that too low interest rates are creating a housing price bubble?"

I am. Low mortgage rates HAVE created a housing bubble which is soon to pop. How bad this bubble is depends on which region of the country you're in.

And yes, even though Fed policy affects the entire economy, an artificially low cost of borrowing makes risky and marginal investments appear more attractive; the result is malinvestment.

Posted by: Kosh on September 10, 2003 08:42 AM

Kosh,

Yes, marginal investments become attractive, and this might involve those which are marginal because of risk. Naturally we use interest rates to resolve where we draw this line. However, I hear very few people complain about the true marginal investments which were made but would not have been made were interest rates one or two points more. As long as we have the capacity and people were willing to save and invest at the lower rates then why would anyone complain?

The bad investments that most people point out are in no way marginal. Global Crossing, Worldcom, other telecoms, Enron, AOL at $80 per share, and all those Nasdaq stocks and IPOs in general were not marginal, they were toilets for dollars.

I calculated in 1999 that assuming current levels of telecom spending and technology improvement continued, there would be the capacity by 2010 for every person on the globe to receive a couple of DVD quality video streams from random locations elsewhere on the globe. I still don't quite understand what business if any Cisco Systems will have 10-20 years from now, but even if 10 yr yields were 2% higher I don't think analysts are going to suddenly agree with me.

Also, to what extent does Fed policy affect the longer yields? If the Fed raised rates now to the level you prefer, what would the effect on 10yr and 30yrs be? Don't they follow inflation more than short term rates?

Posted by: snsterling on September 10, 2003 10:08 AM

What sort of outcomes could we expect if interest rates were held substantially below equilibrium for an extended period of time?

Abysmally low savings rates?

Historically high corporate and consumer debt?

Formation of asset bubbles as investors shift assets out of savings and safe investments because yields are so low?

Overcapacity?

Distortion of the balance between labor and capital resulting in both high productivity and high unemployment?

Any of this sound familiar?

Posted by: Kosh on September 10, 2003 12:43 PM
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