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Mallaby, the Fed, and technocratic illusions.

Summary:
One of the frustrations -- or perhaps challenges -- of studying monetary economics and monetary policy is howFed talk and writing on economic mechanisms, causal channels, and effects of policies is far ahead of our actual, scientific knowledge. And writers outside the Fed go leaps and bounds beyond the Fed in advocating strong policies based ...

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One of the frustrations -- or perhaps challenges -- of studying monetary economics and monetary policy is howFed talk and writing on economic mechanisms, causal channels, and effects of policies is far ahead of our actual, scientific knowledge. And writers outside the Fed go leaps and bounds beyond the Fed in advocating strong policies based on the latest stories.

A good example is Sebastian Mallaby, author of "The Man Who Knew: The Life & Times of Alan Greenspan," who wrote last week in the Wall Street Journal Review, that the Fed should surprise us more.

His basic idea: the Fed should monitor asset prices; diagnose when a boom turns in to a bubble; and then actively suppress higher stock prices. And, in addition to interest rates, asset sales, "macro-prudential" regulation (telling banks to stop lending), the Fed should deliberately surprise markets more, adding volatility, in place of central banks' and governments' centuries-old quest (often illusory) to smooth asset prices.
By being less transparent—and reserving the option of deliberately ambushing investors with a shock move—the Fed could discourage them from taking too much risk. 
The painfully learned lesson from the late 1990s and mid-2000s is that excess financial serenity leads to excess risk-taking, which in turn increases the chances of a blowup.
But the equally hard lesson of 2008 hasn’t yet been absorbed: that they [the Fed] should embrace modest, short-term market instability to head off truly disruptive crashes over the horizon. Instead, the calmer markets remain, the prouder the central bankers feel.
Mr. Greenspan and his colleagues faced the danger that the interest rate that would stabilize consumer prices would also destabilize asset prices. The Fed could have escaped this dilemma by acting less predictably. Instead, it telegraphed its intentions and avoided surprises.
Rather breathtaking, no? The last paragraph adds more -- when the Fed wants to lower interest rates to stoke the economy, that causes "bubbles," and the Fed should offset the bubble with deliberate volatility. Hit the gas and the brake at the same time. Greenspan wasn't obscure enough.


What's wrong with "bubbles" anyway? There is one sensible comment,
..when risks seem modest, Wall Street borrows to make bets that look great based on the Sharpe ratio.
Financial crises are always and everywhere about debt. But if Wall Street debt is the problem, just what is the entire Dodd-Frank apparatus to monitor Wall Street debt all about? Really, if Wall Street defaults are the problem, is deliberately inducing volatility to your and my portfolio the answer? Would not a little more capital be a better idea?

Academics do not know exactly how the financial system works. What I as an academic do know, a little more than the average person, is the limits of knowledge - just how much is not known, what the holes are in stories bandied about, and which stories have no basis yet in theory, experience, or evidence. An academic knows that many stories about how the world works are wrong, and we know that many other stories might be possible but have not been written down coherently and evaluated against experience. Knowing what you don't know is knowledge.

It is amazing in that context how much people advocate strong public policy actions -- actions that cost a lot of money, and threaten to put a lot of people in jail -- on stories that are either demonstrably false, or as in this case have no scientific foundation beyond cocktail party speculation, and many glaring logical holes.

For example, it is commonly bandied about, as in this article, that low interest rates induce investors to "reach for yield,'' and create "bubbles'' in asset markets. This is stated as a known, scientific, fact. I know, though it may be true, that this is not yet a known fact. Known facts have to start with a mechanism. Just what is the mechanism? Borrowing at 1% and lending at 3% is exactly the same as borrowing at 5% and lending at 7%. What connection is there between the level of short-term interest rates and the risk premium reflected in the differences between prospective rates of return on different assets?

Well, there are stories about it. Many theory papers have done so in the wake of such speculation. It takes a lot of friction carpentry -- only leveraged intermediaries hold assets, and a lot of nominal illusion or accounting constraints, so that 7-5 is not equal to 3-1. Yes, past booms have involved credit in some way. But most of the time low interest rates correlate with busts, not booms. There are empirical papers,  that seem to show some effects, with all the caveats about empirical work in economics. But none of this elevates it to a known and verified fact, ready for exploitation by policy makers. [I foresee also a swarm of comments opining that yes, low interest rates cause asset booms, thereby missing the point that we shouldn't make policy on such opinion, but rather on well understood causal channels

Good policy waits for some sort of scientific evidence. We don't want the government jumping on every food fashion that comes out of the organic farmer's markets of Palo Alto either.

And if the idea that the Fed has the technocratic competence to understand the difference between "boom" and "bubble," the political mandate to determine the correct level of stock prices -- something that affects many voter's pocketbooks! -- and is ready to exactly offset its manipulation of  short term rate by deliberately injecting just enough volatility to hold down prices... Well, I titled the post "technocratic illusions" for a reason.

John H. Cochrane
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!

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