Why Don’t Policymakers Respond to Rising Markets ?

Alternative title: Ignore Minsky at Your Own Risk

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Thomas Donlan in Barron’s discusses the asymmetric policy approaches of the Fed. It turns out that Policymakers ought to respond as aggressively to sharply rising markets as they do to rapidly falling ones. That failure is one of the factors in allowing bubbles to form and markets to get out of hand.

Excerpt:

“IN 2007, WHEN TROUBLES BEGAN TO SURFACE in housing, most analysts argued that the problem would be contained. Inflation was low, they said, and the Federal Reserve could keep the problem from worsening by lowering interest rates. As late as last July, a large majority of economic forecasters believed the U.S. would avoid the recession that had already begun.

It is easy to blame incompetent bankers, but a major part of the blame for today’s global crisis belongs to incompetent theories. Economic orthodoxy ties boom and bust cycles to external shocks and inflation dynamics and in so doing treats financial markets as a sideshow. To such economists, shocks cannot be anticipated. Central bankers must respond forcefully if a bolt from the blue arrives…

Goldilocks growth on Main Street invites destabilizing activities on Wall Street. This was the longstanding thesis of the late renegade economist Hyman Minsky. His work was largely ignored by mainstream economists throughout his life. Much of the carnage unfolding today can be laid at the doorstep of central bankers who still ignore Minsky…

Asset bubbles swell when risk appetites are high and credit spreads are narrow. Had the Fed considered spreads in its policies for 2004 and 2005, its tightening might have been much more aggressive. Home prices might have cracked much earlier. And today’s recession might have been much milder…

Central bankers, as we can all see at the moment, are always at the ready to respond to violent increases in credit spreads. When stock and corporate bond markets go into free fall, policy makers ease aggressively, pointing out that investors need to be cleansed of primal fears.

But what about rising markets? For the past 25 years, policy-makers were willing to say they knew better than falling markets but they refused to respond to markets that were rapidly rising. This asymmetry played a major role in the creation of a succession of asset bubbles. And much of today’s crisis stems from this asymmetric response.

Good stuff, Thomas.

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Source:
On the Other Hand
THOMAS G. DONLAN
Barron’s JANUARY 3, 2009
EDITORIAL COMMENTARY
http://online.barrons.com/article/SB123094020271250259.html