You can't fix the problem with asset-based policy
by David Atkins
Nouriel Roubini, one of the great economists who predicted the housing and financial crisis, has an excellent article highlighting the dilemma of central bankers worldwide: use tight money policies that slow growth and cause deflation, or or loose money policies that threaten to reinflate asset bubbles. Progressives naturally tend to favor loose money policies especially in a recessionary environment. Particularly when elected governments seem unable or unwilling to engage in stimulative spending, central banks are frequently the only entities capable of pseudo-Keynesian policy.
But the problem, of course, is that loose money from reserve banks isn't remotely the same as stimulative spending. Most loose money policy goes straight into assets rather than wages. That's better than nothing in a deflationary slow-growth economic environment, but it's not remotely enough. Further, there is a great danger of reigniting another financial powder keg by creating more bubbles.
Some policymakers – like Janet Yellen, who is likely to be confirmed as the next Chair of the US Federal Reserve – argue that we should not worry too much. Central banks, they argue, now have two goals: restoring robust growth and low unemployment with low inflation, and maintaining financial stability without bubbles. Moreover, they have two instruments to achieve these goals: the policy interest rate, which will be kept low for long and raised only gradually to boost growth; and macro-prudential regulation and supervision of the financial system (macro-pru for short), which will be used to control credit and prevent bubbles.
But some critics, like Fed Governor Jeremy Stein, argue that macro-pru policies to control credit and leverage – such as limits on loan-to-value ratios for mortgages, bigger capital buffers for banks that extend risky loans, and tighter underwriting standards – may not work. Not only are they untested, but restricting leverage in some parts of the banking system would merely cause the liquidity from zero rates to flow to other parts of it, while trying to restrict leverage entirely would simply drive the liquidity into the less-regulated shadow banking system. According to Stein, only monetary policy (higher policy interest rates) “gets in all of the cracks” of the financial system and prevents asset bubbles.
The trouble is that if macro-pru does not work, the interest rate would have to serve two opposing goals: economic recovery and financial stability. If policymakers go slow on raising rates to encourage faster economic recovery, they risk causing the mother of all asset bubbles, eventually leading to a bust, another massive financial crisis, and a rapid slide into recession. But if they try to prick bubbles early on with higher interest rates, they will crash bond markets and kill the recovery, causing much economic and financial damage. So, unless macro-pru works as planned, policymakers are damned if they do and damned if they don’t.
For now, policymakers in countries with frothy credit, equity, and housing markets have avoided raising policy rates, given slow economic growth. But it is still too early to tell whether the macro-pru policies on which they are relying will ensure financial stability. If not, policymakers will eventually face an ugly tradeoff: kill the recovery to avoid risky bubbles, or go for growth at the risk of fueling the next financial crisis. For now, with asset prices continuing to rise, many economies may have had as much soup as they can stand.
Not only is loose money policy from central banks not enough, it's actually quite dangerous in the long run without accompanying stimulative policy on the wage side. In the end, if housing prices are rising much faster than wages are growing, it's unsustainable for obvious reasons. Everyone was making too much money in the aughts to pay it any attention, but policymakers are paying more attention now to the gap between wages and housing prices. Ideally, wages and housing prices would rise in tandem, with wages hopefully outstripping assets. Yes, that would cause mild inflation--but that's not a bad thing as long as it's kept relatively under control. During boom times, central banks can raise interest rates and tighten monetary policy counter-cyclically in order to strike a balance and keep inflation in check.
Until the world does something to reverse the growing income inequality and wage stagnation trends, central bankers won't have any good options but to keep monetary policy loose and hope against hope that wages start to go up before the next bubbles pop. That's not a great bet.
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