A New Direction For The Fed?

by Simon Johnson | July 7, 2009

Policymakers like to make particular kinds of statements at a "low attention" moment, e.g., right before a holiday weekend. This gets items onto the public record but ensures they do not get too much attention. And if you are asked about these substantive issues down the road, you can always say, "we told you this already, so it's not now news"--usually this keeps things off the front page.

Released on July 3rd (a federal holiday), and buried inside the Washington Post on Saturday (p.A12): An important speech (from June 26th) by the New York Fed's controversial President, William C. Dudley.

If the Fed is to become the system or any kind of "macroprudential" regulator, what would it do with that responsibility? This is a hot topic for Capitol Hill in coming weeks as various committees take on this topic in whole or part.

Dudley says that the Fed can pop or prevent asset bubbles from developing. This would represent a major change in the nature of American (and G7) central banking.  It's a huge statement--throwing the Greenspan years out of the door, without ceremony.

It's also an attractive idea. But how will the Fed actually implement? Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to "sniff" bubbles accurately--and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious.

Dudley is quiet on whether or not, for example, we have an emergent bubble in emerging markets today. Is there also an effective bubble in U.S. Treasuries, as John Campbell has argued persuasively?

"Asset bubbles may not be that hard to identify," Dudley argues. Fine, but it would help to know exactly the Fed would do this ex ante--not using the rear view mirror.

Of course, if the Fed can't get better at spotting bubbles, the implication is that no one can. Which means that "macroprudential regulator" is just a slogan--a nice piece of what Lenin liked to call "agitprop."

And if macroprudentially regulating is an illusion, what does that imply? There will be bubbles and there will be busts. Next time, however, will there be financial institutions (banks, insurance companies, asset managers, you name it) who are--or are perceived to be--"too big to fail"?

You cannot stop the tide and you cannot prevent financial crises. But you can limit the cost of those crises if your biggest players are small enough to fail.

[Cross posted at The Baseline Scenario.]

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