Geithner vs. Greenspan/Bernanke on Asset Prices and Monetary Policy
It is quite amazing how sometimes the print media totally misses important news stories and how financial markets similarly misread and react in the wrong direction to such stories. The speech yesterday by New York Fed President Tim Geithner (effectively the #2 at the Fed) about how monetary policy should respond to asset prices and asset bubbles represents a potentially significant change in the Fed approach to such issue. As I will argue below the speech presents, in subtle but clear and substantial ways, a view that is different from those expressed over the years by Greenspan, Bernanke, Kohn, Ferguson and other Fed officials. And indeed newswires such as Bloomberg and Reuters understood right away the importance of the speech, even if not fully appreciating its novelty compared to previous Fed official pronouncements. Contrast that to the total silence on this speech by the FT, the Wall Street Journal and the New York Times today. A story that should have been front page on the FT today not only is not in the front page but nowhere else in the paper, either in its print or online edition. That is a bit embarassing for a paper such as the FT that is usually finely attuned to important financial events and monetary policy issues and pronouncements. Similarly, the stock market reaction to the speech is baffling: the U.S. stock market went up – so say the wires – because Geithner argued that inflation is “quite moderate”. The more important implications of the speech for future tighter monetary policy in the presence of asset bubbles – be it in housing or other markets – was totally and altogether ignored. So, indeed, markets are at times inefficient in processing information.
Understanding what Geithner exactly meant, and whether and how much it is different from the views of Greenspan and Bernanke, is very important. I recently wrote a long paper on asset prices and monetary policy criticizing the Fed asymmetric approach to asset bubbles (i.e. the idea that monetary policy should not react to asset bubbles when they are on the way up and should instead be eased when asset bubbles burst).
Some people are already reacting to Geithner’s speech arguing that his views are identical to those of Greenspan: the head of global economics at a financial institution sent me an email this morning arguing that and suggesting that the RGE spotlight issue heading of “Geithner vs. Greenspan/Bernanke” is misleading. His point is that Greenspan, in a series of recent pronouncements – including his opening remarks at Jackson Hole – has recognized the indirect importance of asset prices for monetary policy; thus, in his view Geithner’s speech “is really just an elaboration of Greenspan’s view on the role of asset prices in making monetary policy”.
I beg to substantially differ with this minimalist interpretation of Geithner’s speech. Since this is a difficult matter where subtle words, phrases and interpretations are really important, it is important to carefully deconstruct Geithner’s words and understand why and how they differ from those of Greenspan and Bernanke.
First, note that there is a meaningful difference between the evolving views of departing Fed Chairman Greenspan and those of incoming Fed Chairman Bernanke on asset bubbles and monetary policy. While their speeches on this topic presented almost identical views for a long time (i.e. asymmetric approach to rising and falling asset bubbles with no targeting of rising bubbles; Taylor rule indirectly reacting to asset prices only insofar as those asset prices push growth and inflation away from Fed target but no independent role of asset price on monetary policy separate from their impact on inflation and growth; inability and undesirability of pricking rising bubbles), this year Greenspan views on the subject have evolved quite far from those of Bernanke. For one thing, Greenspan is now much more worried about the housing bubble than Bernanke is: while in 2004 Greenspan was downplaying the existence of a housing bubble, by early 2005 he started to admit that there was some “froth” in housing markets, by August in Jackson Hole he warned about the risk of a housing bubble bursting and the risks of excessively high asset prices and excessively low risk premia (” history has not dealt kindly with the aftermath of protracted periods of low risk premiums”), by September he expressed even more alarm about the housing bubble and excessively low risk premia (see here and here); he also wrote a research paper – his second one in 20 years – to show that most of the consumption growth of the last few years has been driven by the increase in housing wealth and consumers mortgage equity withdrawals. Greenspan’s views on the sustainability of the US current account deficit have also evolved over time with some greater degree of concerns about it expressed in recent times.
Contrast that with Bernanke’s views on asset bubbles and on the current account. Bernanke believes that the US current account is due only to a global savings glut and that the US fiscal deficits have nothing to do with it. He has also been quite blasé about asset bubbles and downplaying their existence and importance in recent US economic history; compared to the increasing noise and worrried by Greenspan – and even Kohn – about housing and asset bubbles, Bernanke’s silence about them has been deafening. He apparently believes that either there are no asset bubbles in the US economy today and/or that we should not worry about them.
Second, the view that Geithner’s speech is nothing new and just an elaboration of previous Fed policy is clearly incorrect. If one wanted to stretch the interpretation of it, one could – in my view wrongly – interpret is as saying that it is similar to departing Greenspan’s views; but it is certainly a meaningfully different view from that of incoming Fed Chairman Bernanke.
Third, the significant novelty of Geithner’s remarks comes from the following points and considerations.
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Geithner starts the speech by saying that ”My remarks are my personal views and do not attempt to represent the views of the FOMC”. This is a signal that he is starting to say something potentially controversial that may not be official Fed policy yet.
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Next, unlike Bernanke, he warns about asset bubbles and excessively low risk premia: “The relatively low compensation for risk priced into asset markets today does not necessarily mean the future will justify that confidence.” This paraphrases and amplifies concerns recently expressed by Greenspan.
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Then, he argues that the uncertainty about future movements in asset prices complicates the task of monetary policy, directly linking monetary policy decisions about possible paths in asset prices: “This uncertainty surrounding the current behavior of asset values complicates the task of assessing the future trajectory of asset prices, and the impact of alternative monetary policy paths on asset values. And by widening the already substantial degree of uncertainty
that surrounds estimates of the equilibrium real rate of interest, these developments complicate the task of assessing the appropriateness of a given stance of monetary policy against the objectives of the Federal Reserve.” -
Then, he argues that possibly monetary policy in the future react more than in the past to asset prices: “as financial markets continue to broaden and deepen, the behavior of asset prices will play an important role in the formulation of monetary policy going forward, perhaps a more important role than in the past” (underline/bold added). This is a crucial sentence that is couched in careful terms with the use of “perhaps” but it is very clear in its message. Relative to the past, Fed policy could react and respond “more” to asset prices and such asset prices may have a “more important role than in the past”. The meaning of such a sentence is clear. While this is not yet official Fed policy and only Geithner’s personal views, he is clearly saying something very different from Bernanke and Greenspan.
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He then points out all the valid cautionary arguments that Greenspan and Bernanke have made before him about not linking asset prices and monetary policy: uncertaintly about the existence of asset bubbles; uncertainty about the impact of asset bubbles on the economy; the risks of pricking an asset bubble as the effects of monetary policy on asset prices are also uncertain. This caution is valid and warranted given that this is a delicate subject on which careful decisions have to be made.
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But, then, he makes another set of statements that are very different from Greenspan and Bernanke. Greenspan and Bernanke have repeatedly argued three important points: 1. we cannot know with certainty whether there is an asset bubble or not; 2. we do not know whether such rising asset bubbles have any negative effect on economic activity while actual evidences suggest that such negative effects are almost never happening; 3. attempting to prick asset bubbles is very dangerous as small monetary policy move have little effects on the bubbles and large ones can cause an economic and financial collapse (“you can’t perform brain surgery with a sledgehammer”).
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On all these three points, Geithner presents a very different view that is closer to that expressed by a broad recent academic and policy literature on bubbles and monetary policy. He first argues – with a clear critique of Bernanke and Greenspan - that acknowledging these uncertainties about bubbles and their effects should not be an excuse for policy inaction: “But to acknowledge these complexities does not weaken the case for the importance of trying to make sensible judgments about how monetary policy should respond to asset price developments.”
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Next, he clearly argues that experience and studies suggest that rising asset prices and asset bubbles can have significant real effect on the economy (thus disagreeing with Bernanke that has repeatedly argued otherwise): “History provides us with numerous examples in which significant movements in asset prices have had sizable effects on the path of output relative to potential and on price stability.”
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He then argues that Bernanke’s and Greenspan’s view that, unless sizable, monetary policy can have little effect on asset prices is not correct: ”experience suggests that asset values can be very sensitive to movements in monetary policy or to the perceptions of future policy moves,”; i.e. you do not need a sledgehammer to perform brain surgery on asset bubble even if, he cautiously acknowledges, this is a most delicate and complicated task.
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Next, he makes a point that matches the current Fed view on an indirect reaction of monetary policy to asset prices, i.e. that the Taylor rule relating interest rates to growth and inflation would imply that interest rates would indirectly react to asset bubbles as long as past bubbles are having a current effect on aggregate demand, growth and inflation: “in circumstances where the central bank observes a large realized movement in asset prices and is confident in its knowledge of the impact of those moves on the path of aggregate demand, monetary policy may need to follow a different path than might have seemed appropriate in the absence of those developments.” In this matter he does agree with Fed view on the indirect effect of asset bubbles on monetary policy. And he also certainly cautions against a direct targeting of particular asset price levels by monetary policy.
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He also paraphrases Greenspan’s justification of why monetary policy response to asset bubbles may be perceived as being “asymmetric”: in Greenspan’s view bubbles that are rising are less dangerous than falling bubbles because the effects on real variables of rising bubbles are modest while falling bubbles are often associated with collapses – not gradually falling – asset prices; and rapidly collapsing asset prices are more dangerous as they can cause systemic effects and lead to severe recessions. Thus, Greenspan argues, monetary policy may look asymmetric only because bubbles are asymmetric, gradually rising and sharply/rapidly falling. Geithner accepts the Greenspan point on this asymmetry but, then, goes on to criticize it: ” But this does not mean that monetary policy should generally ignore the effects of increases and only respond to observed declines in asset prices. The test should be the size and circumstances of the asset price moves and their impact on the forecast relative to the central banks’ objectives, not the direction of the asset price move.” This is a substantially different view compared to Greenspan and Bernanke. The latter essentially argue that rising bubbles should be ignored and the monetary policy response should be asymmetric, reacting only to falling bubbles. Geithner argues the opposite, a more symmetric response to rising and falling bubbles.
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Next, and even more importantly, he even argues that there is some role in monetary policy reacting to future expected movements in asset prices. This is a most delicate issue on which he correctly threads carefully: if monetary policy expects a change in future asset prices – such as a fall in housing prices – and eases in advance in expectation of this but then the asset price does not fall, ex-post monetary policy would have been too easy. then, Greenspan and Bernanke would argue that, given all the uncertainty about past asset bubbles – let alone future ones and their bursting – the best policy is do nothing until the actual asset price changes and it affects real variables. But Geithner presents a different view, even if correctly couched in cautious terms: “despite the fact that policymakers can’t be completely confident in their assessment of the future path of asset prices, it seems unavoidable that these assessments will factor into policy decisions. This is not to say that central banks should lean against bubbles or against asset price movements themselves. Nor should the appropriate response to a given change in asset prices be to change policy by more than what would be appropriate to address the effects on the central objectives of the central bank. But policy, in some circumstances, will need to respond to asset price movements when those movements alter the central bank’s assessment of the risks to its outlook, and that change in the assessment of the risks to the forecast should be part of the central bank’s communication with the public.” Again, Geithner is cautious but he is pushing the envelope on the relation betwen asset prices and monetary policy a couple of steps ahead of Greenspan and several steps ahead of Bernanke.
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Geithner then moves to conclude the speech with the argument that asset price movement matter more than in the past and that this implies important a
nd delicate greater consideration of their role in formulating monetary policy: “This leaves us with no simple or clear doctrine for the role of asset prices in monetary policy regimes. Asset prices probably matter more than they once did, but what that means for monetary policy necessarily depends on the circumstances.” -
He finally concludes by repeating his concerns about the sustainability of the high asset prices and low risk premia observed in recent times and clearly linking flexibly monetary policy to the evolution of such asset prices: ”We live with considerable uncertainty about the sustainability of the pattern of relatively low risk premia and reduction in the cost of insurance against future macroeconomic and financial volatility. That uncertainty necessarily adds to the normally substantial degree of uncertainty we face in making monetary policy judgments. All these factors strengthen the case for being open about what we do not know. And it reinforces the case for preserving confidence in our commitment to keep underlying inflation low over time, and for retaining the capacity to respond with flexibility to the challenges we face in this uncertain world.”
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Finally, one should understand Geithner’s remarks in the context of his other views about risks and vulnerabilities in the US economy. In 2005 he gave four speeches in which he cautiosly warned about systemic risk in financial markets, i.e. the situations like the stock market crash of 1987, the bond rout of 1994 or the 1998 near collapse of LTCM where financial marke disturbances risked to have serious real effects on the economy. His concerns about asset bubbles and how to carefully address them is clearly related to his concerns about systemic risk. He has also expressed stronger concerns – compared to Bernanke and other Fed governors – about the US twin fiscal and current acccount deficits and their sustainability and the implications of these US imbalances for the US dollar and the global economy; and he reiterated his concerns about the US current account deficit in yesterday’s speech. He, like Greenspan but unlike Bernanke – is also concerned about high asset prices, the related low risk premia and the risks of shifts in investors’ perceptions of risk with rapid reversals of asset prices. So, his musing about asset prices and monetary policy also relate to his broader concerns about the serious imbalances in the US economy and the risks of a financial and real sector disorderly rebalancing.
In summary, Geithner is – as usual – very cautious but also very wise in presenting views about monetary policy and risks and vulnerabilities. He has warned in the past about the risks of systemic crises in the financial system; he has expressed concerns about the US twin deficits and the sustainability of the US current account deficit; now he is presently meaningfully new views – that are not yet – Fed policy on how the Fed should think about asset prices and asset bubbles and how it should respond to them. These views are cautiously expressed but clearly and significantly different from those expressed by departing Fed Chairman Greenspan and very different from those expressed by incoming Fed Chairman Bernanke. On twin deficits, the US current account sustainability, the risks of a systemic crisis and, now, monetary policy and asset prices, Geithner appears to have taken careful and cautiously expressed views that are meaningfully different from those of Bernanke.
Caveat: The views presented in this note strictly express my own views on what Geithner said based on a constructive interpretation of his remarks. While I worked for Geithner as his Senior Advisor when he was Under Secretary for International Affairs at the U.S. Treasury, I currently have no direct or privileged access to his mind or views. So, the views expressed here are strictly my own.
10 Responses to “Geithner vs. Greenspan/Bernanke on Asset Prices and Monetary Policy”
RJF • January 12th, 2006 at 8:18 pm
I, like you, was a bit surprised by the silence of the FT, though not by the WSJ(is Brain Wesbury now employed there?). You have to give FT their due though, as they nailed Greespan’s Jackson Hole speech on the head with a front page, front headline reading “Greenspan Gives Sternest Warying Yet on Asset Prices”. As for the rest of the complex, thats more of the same. I watched astonishly as economist after economist interviewed after Greenspan’s speech in Jackson Hole rely that they heard ‘nothing new’. I quickly reread the speech to make sure there was indeed a reason I fell off my chair the first time I read it. Note also that that speech is nowhere to be seen today, though it was indeed extraordinary and a major depature from his previously percieved views on the current environment and monetary policy post .com bubble. Your analysis is spot on, though I wonder if anything more can be gleaned from his comments about halting interest rate increases in expectation of an easing in asset price risies, only to ex post realize that such actions only poured gas onto the fire. As I read it, I wondered if this was indeed his thinking on the current monetary cycle, i.e. stopping now at 4.5 or 4.75% may only serve to give ‘the forces of boom’ a second wind. That appears to be the thought of many of the fund managers and analysts on Wall Street (and the equity markets), as it seems entirely impossible to go one day w/out hearing someone comparing the current environment to 1994/95. But here is the catch, at least to me; if we’re to believe, as Alan Blinder has told us, that the Fed is an “autocratically-collegial committee” where the Chairmen “dictates the consenus” and that “…the group’s decision is essentially the chairman’s decision..” are Geithener’s views going to really play any role come March 28th, the day Gentle/Helicopter Ben takes the reins for his first FOMC meeting?
Butch • January 12th, 2006 at 8:43 pm
Color my cynical, but I consider it quite pathetic that in the U.S.–a supposed bastion of “Free Markets”–we have evolved a Soviet-Stye Central Banking Politburo. The “Central Planners” strut around espousing Socialist Keynsian claptrap theories and the rest of the economic sphere is reduced to playing “parse the phrase”. Meanwhile, the entire world becomes buried deeper and deeper under the terminal-process fiat currency/fractional reserve lending/central banking/structured finance/derivatives Ponzi scheme. Sadly, even big-brained guys like Professor Roubini are caught up in this resource-wasting exercise instead of focusing on the really important issues of the “3Ds” of finance and economics, namely: discipline, denial, and debt-aversion!!! Indeed, we are careening toward the most catastrophic economic meltdown that the world will have ever witnessed. Let us hope that there is a worldwide revulsion of the failed, Socialist central planner paradigm and a return to fiscal sobriety. A sobriety that eliminates fiat currency, fractional reserve lending, and central banking. However, I do not hold out much hope that we will ever reach such enlightenment, even AFTER the economic upheavel which is to come. The temptaion is just too great for The State to monepolize the monetary process and the geleral population is too lazy and ignorant to understand the process, much less demand change. Butch
Stormy • January 13th, 2006 at 12:56 am
Excellent piece of analysis and writing. Catching the bubble on the rise is tricky, though. And are the tools at hand good enough? And what if the bubble is now at its zenith; does the wrong move pour, as RJF suggests, give it a second wind? And how many different types of asset bubbles can the Fed deal with?
HK • January 13th, 2006 at 5:19 am
I happen to have experienced Japan’s huge bubble in the late 1980s and its aftermath of bubble burst in the early 1990s. So, I would argue that (i)too loose monetary policy coupled with lax financial management, whch tends to stimulate asset bubble, must be avoided, (ii)bubble is not easy to detect, but not impossible either, (iii)negative impact of asset price decline must be addressed appropriately. From this experience, the current strong dollar, very low real long-term interest rates and high housing prices appear to be unsustainale, i.e., bubble. So,it seems wise to tighten monetary policy and financial management to avoid further asset price inflation, although, as the Bank of England has done extremely well, soft landing is required and possible. Where he Japanese government and the BoJ failed is not they plicked huge buble, but they first allowed the bubble to become so huge and after bursting the bubble they did not take approriate measures to address its negative impact. I suspect the current US bubble in the asset market is already too big, so that the impact of bubble burst will be fairly serious, though not so serious as Japan’s bubble at that time. However, if left, the US bulle could become bigger and as serious as Japan’s. It is better to avoid it now. Therefore, I share Geithner’s concern, but I am not quite sure whether he is prepared to do something (further tightening of monetary policy and strengthening of financial regulation) now. If not, his statement will be only rhetoric, like famous statement by Chairmen Greenspan on “irrational exuberance”.
RES • January 13th, 2006 at 7:33 am
Is G’s accent on pure symetry, or on actual diagnosis of a current bubble condition? Policy more reactive to asset prices in general would mean that in the future, when RE prices finally begin falling, the FED would losen financial conditions MORE than it would have under Greenspan.
RES • January 13th, 2006 at 7:33 am
Is G’s accent on pure symetry, or on actual diagnosis of a current bubble condition? Policy more reactive to asset prices in general would mean that in the future, when RE prices finally begin falling, the FED would losen financial conditions MORE than it would have under Greenspan.
Guest • January 13th, 2006 at 10:25 am
The combination of dramatically loostened mtg. lending criteria with interest rates left way too low for way too long created & fed the r.e. bubble that MUST unwind. To suggest the Fed was unaware of the outcome of its own policies & those of the Administration is absolutely ludicrous. The Fed sets ff rates, it supervises the banks that led the credit loosening assault on reason & it is better aware of GSE practices than any other “independent” body. It was the Bush Administration that wanted to increase percentage of people owning homes. It was the “independent” Fed that hid its head in the sand instead of advising Bush to the long-term cost of throwing credit at those unprepared to manage it.
Algernon • January 14th, 2006 at 12:27 am
Austrian economists deal with this with some elegance. Where interest rates are determined by markets, to wit the money that is borrowed must first be saved (as opposed to being created by a central bank), interest rates will rise when demand for investment in assets rises. Demand for investment is thereby moderated & asset bubbles become less likely. Where interest rates communicate the interplay of the supply of savings & the demand to borrow, misallocation of resources (=asset bubbles) is/are avoided
DF • January 23rd, 2006 at 11:12 am
Austrian economics are a joke. Even marxists do better. Aside from this, given the difference between Bernanke and Geithner it’s no surprise Bernanke got the job. Bush is not a member of the fact based community. Whatever the future policy of the Fed, the rubicon has been crossed a long time ago. The real question now is how much liquidity the FED is ready to pump into the economy to escape a massive deflation crisis (the second is can we escape war as the traditional mechanism in solving economic crisis). Bernanke has talked loud, but so far there has been no action taken to reduce debt creation and print tons of money into existence in order to reduce the present excess in debt level… Who will have the courage to destroy the illusory wealth ?
Guest • February 27th, 2006 at 3:27 am
Greetings, Here is a letter that you may find interesting regarding the fraud known as Monetary Policy. If any wish to challenge or refute this, I shall be most grateful. Mr. Karlsson writes that as the Federal Reserve Sytem controls the money supply, Mr. Greenspan as its chief must bear responsibility for every financial calamity or success in the United States during his reign. But does Mr. Greenspan in fact wield such financial power? Mr. Karlsson should furnish some evidence for his incredible claims. The assets of the US Federal Reserve stand at some $800 billions representing the totality of US currency in existence, a considerable fraction of which circulates beyond the nation’s borders. However, the combined assets of US banks must stand at least 15 to 20 times this amount or more. Financial power consists in the control of the supply of and demand for credit. Though the US Federal Reserve is large, it little compares with the size of the credit markets in which it operates and supposedly dominates. As the Federal Reserve is clearly dwarfed by the financial market, it can only exert negligible influence. Many monetarists will argue that the Federal Reserve need only reign in the overnight market to impose its will on the immediate and longer term credit markets. But the Federal Reserve is only a competitor in the overnight markets as many other institutions vie for such business. It must therefore lend at rates competitive with other large lending institutions. In order to dominate, it must offer a rate lower than its most able rival. And does it? The Federal Reserve does very little lending in the overnight markets. It is known to many as the lender of last resort, and for good reason. Use of the fund is an indication of financial trouble. Thus, only troubled financial institutions unable to secure funds elsewhere will approach the Reserve for relief. So, the overnight market it serves is a meager one. With such a small place in a very small overnight market, how can the Federal Reserve command such power not only in the overnight markets, but throughout the much larger and longer term financial markets? Mr. Karlsson suggests that the Reserve can compel banks to accept the currency that it alone produces. Any bank can refuse to accept the currency. Financial institutions will take currency only if demand, say from bank customers, dictates such a course. If Mr. Karlsson means that the Reserve is issuing currency to pay the US Government’s bills, then the banks will probably accept the currency. But the US Government would never resort to paying its bills with currency. It is highly inflationary. $1 of currency, through repeated lending, can create financial assets many times this amount, say $20. If the US Government were to pay its bills with $50 billion of manufactured currency, this would eventually enlarge the stock of money by some $1 trillion dollars, depreciating the value of money. The Government would be better off just borrowing the $50 billion, creating inflation of approximately 1/20th the amount. To insist on paying its bills with currency will destroy the country’s financial system. So I would ask Mr. Karlsson to cease attributing blame for calamities until he has verified that Mr. Greenspan does in fact exercise the kind of power as alleged. As for the gold standard, it always has been and always will be a great fraud; For the supply of gold has nothing to do with the supply of and demand for credit. Many factors drive the credit markets, all of them having nothing to do with the rate at which gold is mined. As soon as one were to fix an amount of gold to one dollar, then the completion of one loan, the instant creation of money, would destroy the carefully constructed relationship. The creation of money through loans enlarges the money supply, which enlarges the currency supply, which undermines the original fixed relationship of gold to dollars. The stationary supply of gold would cover only an ever inferior amount of money than initially pleged, then only currency, and then not even currency, as in fact always occurred. Regards, Gary Marshall
