Financial News, a Dow Jones Company, 18th June 2010
Managing the economy is difficult, as recent events have only too clearly shown. Having the right structure for management is only half the battle, but is an essential part that we have previously lacked. Previously the missing element has been the lack of anyone having clear responsibility for what has become known as macroprudential management. In essence this means avoiding the sort of post-bubble crashes that make ineffectual the use of interest rates to manage the economy.
Asset prices are a key transmission mechanism through which interest rate changes by central banks affect the economy. When asset bubbles break, however, the mechanism breaks down. Interest rate changes have only an ephemeral impact on asset prices. The underlying value of shares and houses are not affected by changes in interest rates and, over time, they rotate around their underlying value. When assets become seriously overpriced they fall, even if interest rates are also brought down. The result is that central banks lose control of the economy when asset bubbles break. As we have seen, the consequences for the economy are very bad indeed. It takes unorthodox monetary measures, such as quantitative easing and huge budget deficits to get the economy back on track. Furthermore, the power to repeat the dose is limited should the economy get into trouble again.
It is therefore essential that asset bubbles are pricked before they become too dangerous. The failure to do this, despite the evidence from the Japanese bubble that ended in December 1989 and the great crash of 1929, is the cause of our troubles today. Unfortunately the Federal Reserve under Alan Greenspan and Ben Bernanke made two great intellectual mistakes. First, they argued that asset bubbles did not matter and second that, if they broke, they could readily get the economy back into equilibrium. We now have ample proof that those who disagreed with these views were right to do so.
But even if the Federal Reserve’s understanding about the importance of bubbles had been very different, it was not clear that they would have acted very differently. It would have been very difficult for any central bank to take action to puncture bubbles, unless it had been given a clear mandate to do so with legislative backing. The key element in yesterday’s announcement by the Chancellor of the Exchequer is that the Bank of England will be given such a mandate and with the promise that it will have some special weapons that it can employ to carry it out. The other elements in the announcement are of minor importance.
It seems clear that the Bank will have two rôles in future. Rather than just seeking to achieve a low and stable rate of inflation, it will seek to avoid major recessions and thus the asset bubbles and credit excesses that precede them. It will be important, as seems rightly to be intended, to keep the two rôles separate, so that action designed to avoid financial excesses does not get confused with action designed to keep inflation on its desired path. Prior to the announcement there were fears that the vital distinction between micro and macroprudential management would be blurred in the new structure. Happily that is not the case. The new structure should therefore be welcomed. It is of course only half the battle. The job of avoiding major recessions still needs to be done and will not be easy.
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This article first appeared in Financial News.
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