So everyone's saying that regulators need to step up in the future to choke off bubbles before they get out of control.
Brad Delong writes about this, and
a commentator goesIf effective regulation won't be forthcoming--whether due to regulatory capture or because financial innovation has outpaced the political system's willingness to extend regulators' reach--the central bank might have to tighten into the bubble. I call that Second-Best Punchbowlism...And Brad's all
This seems to me to be exactly right... Central banks would prefer an effective system of regulation, but due to capture of legislatures by the ban[k]ing sector they are unlikely to get it. Thus they are going to be driven to be always wondering whether they should be putting extra downward pressure on asset prices--with implications for employment and possibly growth. The fact that "Punchbowlism" can be implemented by central banks by themselves makes it the default option.This is the argument that Bob Barbera and I have been making for awhile now: the Fed needs to pay more attention to risk premia. But then some crazy guy tosses in his two cents in the comments section:
Oh, weep for those poor central bankers who so desperately want effective and comprehensive regulation of the financial sector! Oh, were it not for the bitter fruit of democracy that imposes upon these wise Platonic technocrats the corruption of legislatures - bodies so easily captured by the dark forces of financial interests.
And, tragically lacking the regulatory tools they need to fulfill their proper role in the Republic, central bankers may need to use the blunt instrument of monetary policy rather than the skillfully-wielded scalpel of regulation.
This seems to me a story that badly misunderstands the nature of regulatory capture and serves primarily as a myth with which central bankers far gone in fantasies of moral self-justification can comfort themselves while walking through the revolving door between the financial sector and (nominal) public service. It ignores the history of how central bankers have actually behaved when they have had regulatory power and elides even the basic arguments put forward by Galbraith to explain the NY Fed's behavior (specifically its failure to "take away the methanol-and-vodka-spiked punchbowl") in 1929.
The truth may be out there, but the lies are in your head.And it turns out I agree with the crazy guy too! I believe, and my research suggests, that the Fed's policy choices are constrained by the political lay of the land. Not to say that the Fed takes orders from politicians or bankers; rather, the Fed does not / cannot adopt a monetary policy strategy that runs seriously counter to the agenda of powerful political interests.
Case 1: the Great Inflation. The Fed spent the decade of the 1970s figuring out ways to contain inflation. But one strategy - the only one that could possibly have been successful - was taken off the table. That was to tighten monetary policy severely enough to push the economy into a severe enough recession that inflation expectations would have been vanquished. That policy was not acceptable because Congress, the President, and the public would not have accepted a continued monetary tightening during a severe recession. The result was gradualism, price controls, reliance on fiscal policy, and the like. Only when Jimmy Carter through up his hands and gave Paul Volcker a blank check to contain inflation was inflation brought under control.
Case 2: Capture by the banking system. I wrote a paper a few years ago that had the most remarkable econometric result: before 1979, the federal funds rate was correlated with "signals" from nonfinancial interest groups like the AFL-CIO and Chambers of Commerce, and not correlated with signals from the banking industry. Nonfinancial groups always wanted a looser monetary policy, and the Fed conducted a monetary policy consistent with those wishes. From 1979 to 2001, the federal funds rate was not correlated with signals from nonfinancial interest groups, but strongly correlated with signals from the banking industry. The banking industry wanted a fairly tight monetary policy, and the Fed's policy was consistent with those wishes. One can interpret these results to mean that the Fed had adopted the preferences of the banking industry, perhaps through a form of regulatory capture. That's not all bad - capture by the banking industry could insulate the Fed from the type of political pressure it came under in the 1970s, allowing it to pursue a more cautious and stable monetary policy that brought benefits to us all.
But think about the constellation of political interests shaping monetary policy today. There is no longer a banking industry but a vast financial services sector where the mundane business of commercial banking is mixed with investment banking, wealth management, and hedge fund - type speculation. The interest of the financial sector in the mid 2000s, and one assumes today, is easy money. And so that's what the Fed is likely to deliver. Where was the political constituency that could have supported a decision by the Fed to tighten interest rates during the bubble period of 2004-07? Where is the political constituency that will do so in the future?
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