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Sunday, November 15, 2009

Mishkin smackdown by Edward Harrison

Ascribing economic understanding to Fed officials is a popular activity, but is misplaced. Absent complicity from the Fed we would have had neither the dot.com crash nor the housing bubble and crash, nor the securitization debacle. Recently Frederic Mishkin, a former Fed official opined that a "pure irrational exuberance bubble" is not as dangerous as a credit boom bubble. Harrison here corrects that nonsense. But it has to be noted that there is no bubble without easy credit, cheap money and lots of it. The ridiculously low margin requirements for trading accounts in the dot.com boom, the stupid lending standards and the Fed's 1% interest rate policy. Credit is the air that blows up bubbles.
All bubbles are equal, but some bubbles are more equal than others
Edward Harrison
Credit Writedowns
November 10, 2009

Columbia University Professor and former Federal Reserve official Frederic Mishkin wrote a much-discussed Op-Ed in the Financial Times yesterday. In it, he asks

Are potential asset-price bubbles always dangerous?

He answers this question with a no, noting that some asset bubbles are more dangerous than others because of their connection to debt and credit. I agree with his delineation and assertion that some asset bubbles are more dangerous than others. But, his conclusion that the non-credit variety of asset bubble — what he calls the “pure irrational exuberance bubble” — is not dangerous is false. This is the same blinkered thinking which led to Nasdaq 5000 and its crash. Experience demonstrates that all asset bubbles are dangerous, some asset bubbles are more dangerous than others. Think Animal Farm: All bubbles are equal, but some bubbles are more equal than others.

The real question Mishkin attempts to answer is whether the Federal Reserve (where he once worked) or any other central bank should target asset prices so as to prevent bubbles from taking form.

Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.

Are we to take this seriously? Even Alan Greenspan is showing more realism in the wake of our latest bubble. This man is outright dangerous. Don’t be fooled; his piece is a plant. We have some serious asset bubbles forming right now and he is looking to give intellectual cover to the watch-the-bubble-and-clean-up-after-the-mess policy we saw on display in the late 1990s. Yves Smith thinks there is a connection between his statement and likely Federal Reserve policy.

What I find interesting is how the Federal Reserve under Greenspan had an explicit policy of targeting asset prices as a means of reflating the economy. Yet, Mishkin is saying they should not target asset prices as a means of deflating the economy. This is what is called monetary policy asymmetry, otherwise known as the Greenspan Put. It’s not about targeting asset prices but looking for excess credit growth, which was certainly on display in the Nasdaq boom as well.

In effect, Mishkin is arguing for us to continue with business as usual. This is one of the more loathsome pieces of prattle I have witnessed since the financial crisis began. I hope no one takes this man seriously. I am ashamed that he is a professor at the business school I attended.

I would be remiss if I didn’t point out his equally absurd piece of research on Iceland’s economy before it collapsed. he wrote a piece called “Financial Stability in Iceland” with Tryggvi Herbertsson which stated:

Our analysis indicates that the sources of financial instability that triggered financial crises in emerging market countries in recent years are just not present in Iceland, so that comparisons of Iceland with emerging market countries are misguided.

No, Mr. Mishkin your analysis is misguided. It was with Iceland and it is here again. See below for a real analysis on Iceland from Willem Buiter and Anne Sibert which we can take seriously.

As I have been saying, you can get wildly different conclusions from two people based on the same facts and largely the same analysis. It goes to philosophical predisposition. What this FT article by Mishkin demonstrates is that no amount of real world evidence of the havoc that bubbles wreak will dissuade these ivory tower ideologues from supporting failed economic policy.


Not all bubbles present a risk to the economy – Frederic Mishkin, FT

Financial Stability in Iceland (pdf) – Icelandic Chamber of Commerce

The collapse of Iceland’s banks: the predictable end of a non-viable business model – VoxEU

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