Reviewing Sebastian Mallaby’s biography of Alan Greenspan, Randall Kroszner writes,
The Fed has limited instruments at its disposal—primarily its control over short-term interest rates—and trying to use this tool for “bubble bursting” while still addressing the Fed’s traditional mandates for full employment and low and stable inflation could lead to conflicting prescriptions. Better, Mr. Greenspan believed, to be ready to clean up the debris if a bubble were to burst, as in 1987. Mr. Mallaby argues that the inflation-targeting framework, which focused central banks world-wide on the goal of low and stable inflation in response to their bad behavior in the 1970s when they eased credit in the short run to boost employment, provided an intellectual underpinning for Mr. Greenspan’s approach.
Indeed, it is useful to go back to what economists were thinking back when Olivier Blanchard was writing that “the state of macro is good.” The idea was that the GDP factory slumped when there were inflation “surprises,” in which prices increased more slowly than expected, leading to real wages that were too high. So if the Fed kept the inflation rate predictable (and it might as well shoot for a predictable rate that was low), then everything would be fine.
Some remarks:
1. Now, journalists want to paint Greenspan as a great free-marketeer, as if he spent his career fending off cries for more financial regulation. In fact, there was a consensus in the 1980s that inter-state banking had to arrive and that the Glass-Steagall separation of investment banking from commercial banking was being eroded by innovation. The deregulation that ratified these changes would have happened under any conceivable Fed chairman at that time. Moreover, the deregulation was accompanied by what banking officials were convinced at the time were stronger and more effective regulations regarding safety and soundness. They were particularly proud of risk-based capital regulations, and it was the market-oriented economists of the Shadow Regulatory Committee who warned that those were not adequate to prevent a crisis.
2. The “(dis-)inflation surprise” theory of economic slumps is now gone. The closest thing remaining is Scott Sumner’s slower-nominal-GDP theory of slumps. That one works for the post-financial-crisis recession because real GDP went way down, which (a) meant that nominal GDP growth was slower than previously and (b) tautologically, there was a slump. I am troubled by the tautology aspect.
3. However, the Keynesians who dominate the current macro conversation have different theories. Some like to tell a story about consumer debt. Many like to tell a story about a liquidity trap.
4. Speaking for macroeconomists in general Blanchard is now open to many different ideas. However, the one idea that they will not consider changing is the GDP factory. Thus, the idea that patterns of sustainable specialization and trade matter is not on the radar screen.
1. People forget how crazy our banking system used to be and how hard it was to travel across state lines.
2. I really wish after 2008 we analyzed the Savings & Loan Crisis and Resolution a lot more. That accelerated the consolidated the banking a lot in early 1990s and the growth of Frannie. That is what killed most of the James Stewart S&L community banking more than anything.
3. Since 2008, more people use big banks and it is probably a convenience ATM factor more than anything. I don’t like Wells Fargo one bit but at least it is easy to get cash. Done properly, Economies of Scale is very powerful in the economy.
Seems to me that Greenspan gets a pass for not reigning in the banks. The expansion of credit took place with banks exposure increasing both on balance sheet and off balance sheet and Greenspan could have easily told them to lower their asset exposure via selling assets or raising capital. Leverage ratios once upon a time were looked at as a way to evaluate bank creditworthiness. Greeenspan should have said lower exposures or raise capital all with in his purview as the Fed regulates banks.
‘… Scott Sumner’s slower-nominal-GDP theory of slumps. That one works for the post-financial-crisis recession because real GDP went way down, which (a) meant that nominal GDP growth was slower than previously and (b) tautologically, there was a slump. I am troubled by the tautology aspect.’
Having been almost ‘present at the creation’ of Scott’s The Money Illusion, I have to say I don’t recognize your characterization of his ‘theory’. His nominal GDP target is just that, not a theory of causation.
All he is saying is that central banks need a reliable indicator to target, and neither interest rates nor monetary aggregates are that. It’s his contention that NGDP is better as a signal of what the Fed should be looking at when they decide on policy.
What would be a better ‘nutshell’ for his ‘theory of slumps,’ is; recessions are, almost always and everywhere, monetary phenomena.
To sk:
Just to clarify something …
Applying the term, “the banks”, as is too often done, grossly obscures critically important distinctions in financial operations, particularly for “large” and/or combined-services financial firms.
For example, you state: ” … Greenspan could have easily told them [“the banks”] to lower their asset exposure …”.
In fact, neither Alan Greenspan nor the Federal Reserve System (Fed), had any regulatory authority over either “Investment” banking operations, nor on “Insurance” operations, of combined financial firms/bank holding companies – even after the 1999 Gramm-Leach-Bliley (GLB) legislation.
The Fed (Greenspan/Bernanke) only had regulatory authority – and “support” facility via access to the Fed “discount window”, etc. – over the “Commercial” (depository) operations of any financial firm – even large, combined bank holding companies. “Investment” banking operations continued to be regulated (but not “supported”) by the Securities Exchange Commission (SEC) and “Insurance” operations continued to be (primarily) regulated by individual state insurance regulators.
Well aware of what a bank is and the point is the JPM’s, CITI, BAC were the major originators of housing securities and the Fed/Greenspan had the authority to do what i stated. Other players were purchasers of these securities that banks either originated or packaged and sold via on balance sheet or off balance sheet