“How to Prevent the Great Depression of 2009”

Roger Farmer says the Fed needs to target an asset price index “to prevent bubbles and crashes”:

How to prevent the Great Depression of 2009, by Roger E.A Farmer, Financial Times: …Since world war two, economic policy in most western democracies has been based on Keynesian economics. But although policy makers still rely on Keynes’ ideas, academics gave up on his theories 40 years ago and went back to classical economics… The result has been 40 years of disconnect in which policy makers are tinkering with the engine without a manual. …

We have seen economies stagnate for a decade or more in the past – the UK in the 1920s, the US in the 1930s and Japan in the 1990s – and it would be presumptuous to think that this cannot happen again when the existing dominant paradigm says that it could not happen in the first place.

Classical economists argue that falling wages will restore equilibrium; but this is based on the belief that the labour market works like an auction in which employment is determined by demand and supply.

It ignores the very real frictions involved in searching for a job by both households and firms that can lead to many possible equilibrium employment levels just as Keynes argued in the General Theory. …

So where do we go from here? The only actor large enough to restore confidence in the US market is the US government. The current policy of quantitative easing by the Fed is a move in the right direction but it does not, as yet, go nearly far enough.

It is time for a greatly increased role for monetary policy through direct intervention of central banks in world stock markets to prevent bubbles and crashes. Central banks control interest rates by buying and selling securities on the open market.

A logical extension of this idea is to pick an indexed basket of securities: one candidate in the US might be the S&P 500, and to control its price by buying and selling blocks of shares on the open market.

Even the credible announcement that a policy of this kind was being considered should be enough to boost the markets and restore consumer and investor confidence in the real economy.

Critics will argue that this policy is dangerous socialist meddling. But I am not arguing that the government should pick winners and losers: only that it should stabilise a broad basket of stocks.

This policy would still allow poorly run firms to fail but it would not allow all firms to fail at the same time. Although the free market is very good at deciding how many left and right shoes to produce, it cannot prevent systemic risk that arises from the psychology of herd behaviour. This is a job for Uncle Sam.

As I’ve noted many times, most recently here, I am also warming up to the idea of having the Fed target an asset price index in addition to inflation and unemployment. But there are lots of questions to be answered first. What growth rate in the stock price index should we target? Should it be 8%? Lower? Higher? What is the correct time frame? Day to day fluctuations are quite volatile, we wouldn’t want to react to every movement in the index, so how do we come up with a core measure that gives us an indication of the long-run trend in stock prices? Does value weighting, as in the S&P 500, give the optimal index, or would some other weighting scheme do better? Do we only include financial assets, or should other asset prices such an housing price index also be targeted? If so, how would we do that? When targets are in conflict, how much weight should deviations of the asset price index from its target value be given relative to deviations of inflation and output from their target values? Will it still be true that it is optimal for the Fed to react by raising the federal funds rate more than one to one in response to changes in inflation? How will adding another source of variation to the federal funds rate affect its smoothness? We don’t fully understand why interest rate smoothing is an important component of the Taylor rule, but it does seem to be an important, so how will this change will affect smoothness (it depends upon how the coefficients in the Taylor rule are adjusted after the new piece is added)?

And that’s just a few of the questions, I’m sure I’ve overlooked many more (and please feel free to fill in the missing pieces in comments). Thus, while I certainly think this is a fruitful area to investigate, particularly in light of recent experience with the housing and stock price bubbles, we have more thinking to do and more regressions to run before we are ready to implement this kind of policy.

Finally, even with theoretical and empirical support, I’d be wary that asset price targeting alone will be enough to prevent problems in asset markets from developing in the future. Asset price targeting is a complement to other measures such as regulatory and enforcement changes, not a substitute, and I think it would be a mistake to believe simply twiddling with the policy rule will be enough to avoid another financial market meltdown that threatens the wider economy.

Originally published at the Economist’s View reproduced here with the author’s permission.

2 Responses to "“How to Prevent the Great Depression of 2009”"

  1. Guest   December 31, 2008 at 12:09 pm

    the fed is already targeting the S&P–ask experienced equity traders or some of the market makers wiped out by Fed(plunge protection team actions) before options expiration. they also know if the S&P 500 goes below a certain level the insurance industry could blow up from all of the structured product they have underwritten.The Fed is the new dictatorship that we are dealing with and is the greatest threat to democracy in our history.

  2. Dan Herkes   December 31, 2008 at 10:57 pm

    The Fed is reacting to a situation, born of theft and deception, unparalleled in history. You are correct in saying that they are are a threat to Democracy.