Saturday, March 29, 2008

Why "Hands-Off" Policy Really Isn't Hands-Off

Bloomberg news reports that more and more within the Fed question the Greenspan-Bernanke policy of "allowing" asset price bubbles to be created and then try to deal with the problems this creates by lowering interest rates and bailing out bankers. This is viewed as asymmetric and is therefore considered to be a damaging policy.

I agree that the Greenspan-Bernanke policy is a damaging policy. My problem is with the presumption that this somehow represents laissez-faire or hands-off during the creation of the bubble. In fact, the bubble is just as much a case of intervention as the Fed's post-bubble actions.

This does not necessarily mean that interest rates are reduced during the bubble compared to before. Sometimes that is in fact the case, as we saw during the first 3 years of the housing bubble, but it is not always the case and it need not be the case. All that is needed is that the central bank holds interest rates lower than they otherwise would have been by increasing the money supply.

Under a free market monetary system, if for some reason people gain irrational exuberance about some asset class, than this would automatically raise interest rates. This would make it a lot more expensive to borrow for such investments, and also make it more profitable to buy bonds rather than that asset class, and so automatically prevent any significant bubbles.

The free market solution to bubbles is of course to abolish central banks and replace them with gold or possibly some other specie based currency that the market chooses. Short of that, however, a policy which more or less automatically raised interest rates whenever there were signs of asset price bubbles would actually be more neutral to the market then a policy which instead allowed money supply growth to accelerate. Such a policy, or a similar policy of targeting very low money supply growth, would imitate the market response and for that reason, constitute less intervention than the Greenspan-Bernanke policy of fueling asset price bubbles with a higher money supply.


Anonymous Jeff Wartman said...

There's an old rule of thumb: when the government wants to give itself more power to keep things "stable", it's never a good thing.

6:26 PM  
Blogger Flavian said...

Since the present monetary system is not based on gold there is no natural inflation constraint in the system and for this reason good central banking under fiat paper is a succesful mimic of the gold standard. If you look at how often the Bank of England lowered and raised the Bank rate in order to offset gold flows during the hey-day of the classical gold standard, you will see that monetary policy under a gold standard is anything but "hands off".

12:15 AM  
Anonymous newson said...

but flavian, surely the difference is that the gold outflows, caused by a a lack of public confidence in monetary policy, forced the central bank into remedial action. there was a proper feedback mechanism.

besides, the classical gold system wasn't an authentic gold-money. but this ain't my blog, so perhaps stefan will elaborate.

12:03 PM  
Blogger stefankarlsson said...

I don't think there is much need to elaborate. As newson points out, the classical gold standard wasn't a pure free market system, particularly not when there was central banks.

Moreover, higher interest rates in one country in response to gold outflows is hardly a unnatural response. Interest rates are the price of money, and if money becomes more scarce because of for example outflows, then interest rates should rise, so this is in fact consistent with market mechanisms. Flavian doesn't seem to have read the original post very carefully, as one of the main points is that unchanged interest rates can be as much of a government intervention as a change in interest rates.

9:30 PM  

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