Sunday, August 24, 2008

Fireworks at Jackson Hole: Buiter Let's It Rip

At the Jackson Hole, Wyoming Federal Reserve conference, London School of Economics professor and former Bank of England and European Bank for Reconstruction and Development official, Willem Buiter, ripped into the manner in which the Federal Reserve, the European Central and Bank of England have handled the current financial crisis. His remarks were particularly critical of the Federal Reserve claiming the the Fed is too close to Wall Street:

Cognitive regulatory capture of the Fed by Wall Street resulted in excess sensitivity of the Fed not just to asset prices (the ‘Greenspan- Bernanke put’) but also to the concerns and fears of Wall Street more generally.

The Fed listens to Wall Street and believes what it hears. This distortion into a partial and often highly distorted perception of reality is unhealthy and dangerous.
He charged that all three banks went well beyond what was necessary to stabilise the financial sector:

All three central banks have gone well beyond the provision of emergency liquidity to solvent but temporarily illiquid banks. All three have allowed themselves to be used as quasifiscal agents of the state, providing subsidies to banks and other highly leveraged institutions, and assisting in their recapitalisation, while keeping the resulting contingent exposure off the budget and balance sheet of the fiscal authorities. Such subservience to the fiscal authorities undermines the independence of the central banks even in the area of monetary policy.

He listed three factors contributing to the Fed's poor performance in handling the crisis:

[T]hree factors contribute to Fed’s underachievement as regards macroeconomic stability. The first is institutional: the Fed is the least independent of the three central banks and, unlike the ECB and the BoE, has a regulatory and supervisory role; fear of political encroachment on what limited independence it has and cognitive regulatory capture by the financial sector make the Fed prone to over-react to signs of weakness in the real economy and to financial sector concerns.

The second is a sextet of technical and analytical errors: (1) misapplication of the ‘Precautionary Principle’; (2) overestimation of the effect of house prices on economic activity; (3) mistaken focus on ‘core’ inflation; (4) failure to appreciate the magnitude of the macroeconomic and financial correction/adjustment required to achieve a sustainable external equilibrium and adequate national saving rate in the US following past excesses; (5) overestimation of the likely impact on the real economy of deleveraging in the financial sector; and (6) too little attention paid (especially during the asset market and credit boom that preceded the current crisis) to the behaviour of broad monetary and credit aggregates.

All three central banks have been too eager to blame repeated and persistent upwards inflation surprises on ‘external factors beyond their control’, specifically food, fuel and other commodity prices. The third cause of the Fed’s macroeconomic underachievement has been its tendency to use the main macroeconomic stability instrument, the Federal Funds target rate, to address financial stability problems. This was an error both because the official policy rate is a rather ineffective tool for addressing liquidity and insolvency issues and because more effective tools were available, or ought to have been. The ECB, and to some extent the BoE, have assigned the official policy rate to their price stability objective and have addressed the financial crisis with the liquidity management tools available to the lender of last resort and market maker of last resort.
It is difficult to argue with Buiter on these points. Indeed, the Fed's reliance on the Fed Funds rate target as its chief monetary tool is currently ignoring the fact that there is little growth in the money supply. Ignoring money growth is also a charge Buiter makes of the Fed: "too little attention the behaviour of broad monetary and credit aggregates."

Unfortunarly, reports out of Jackson Hole suggest that rather than take Buiter's critque to heart and learn from it, members of the Fed and others have chosen to attack the analysis:

Fed Governor Frederic Mishkin said Buiter's paper fired ``a lot of unguided missiles,'' and former Vice Chairman Alan Blinder ``respectfully disagreed'' with his analysis of the central bank's crisis management.....Mishkin lashed out against Buiter's assertion that the Fed's rate reductions may cause higher consumer prices.``I wish he had actually read some of the literature on optimal monetary policy, because it might have been very helpful in this context,'' said Mishkin, who collaborated with Bernanke on inflation research in the 1990s. Mishkin, a leading advocate of the Fed's effort to sustain economic growth through rapid rate reductions, said research shows that ``what you need to do is act more aggressively.''

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