The following is from David Tice's Symposium on the credit bubble. It's the view of Henry Kaufman as posted at the Prudent Bear Web Page.
"So let me conclude by identifying a number of lessons for official economic and
financial policy-makers. One, policy can not be predicated on the assumption
that reasonable financial behavior is the norm. To the contrary, we have learned,
and official policy makers should have learned that during times of market
prosperity, when asset values are advancing and good times are being
extrapolated by the market, analysts and government officials alike, cautionary
words are disregarded or even ridiculed. Asset values can be driven to
unwarranted levels. Risk can be systematically underestimated. Credit quality
yield spreads can be compressed far below what would be adequately needed
to compensate investors. The flip-side is that when the bubble is to burst, and
investors take flight, modest changes in policies that would have had the useful
effect in dampening enthusiasm during the rally have virtually no impact
whatsoever in restoring market conditions. In other words, reasonable financial
behavior is lacking in the downside as well as on the upside?
There are lessons for our own central bank, the Federal Reserve. The backdrop
is the following: It is always going to be the case that the basic objective of
monetary policy is to achieve a balance of sustainable economic growth and
stability of prices. Price stability is almost always thought of as the stability of
prices of goods and services. But there is another dimension, as we all heard
the price of financial assets and real assets. The dilemma for monetary policy is
to what extent the Federal Reserve should take into account inflation in asset
prices as it formulates monetary policy. Inflation in asset prices is highly popular
as we hard this morning. Whereas inflation in the prices of goods and services
usually hurts the individual or the average family. However, excessive inflation in
financial asset prices sets in motion a series of forces which over a period of
time can undermine the foundation of a stable economy. For one thing, it stifles
the incentives to genuinely save. The past few years, as you all know, we have
had an enormous increase in financial wealth while fresh savings, meaning out
of income of individuals, has amounted to very little. In the meantime, excessive
inflation in financial asset prices can breed excessive business investment,
contribute to undue economic and financial concentration, and encourage
questionable flows of funds into risky markets on the part of inexperienced
investors and others. In its policy decisions the Federal Reserve has not yet
placed any weight on the huge increase in financial asset values. Indeed, there
seems to be an asymmetrical approach. The record shows that when asset
prices have suddenly fallen, as in 1987 and again in the fall of last year, the
Federal Reserve eased monetary policy to take account of the need for the
financial markets for greater liquidity at a time of stress. Also, it may have
wanted to counteract the potential compression in domestic spending that might
have been caused by the loss of financial wealth. But there is very little evidence
of a symmetrical response when asset prices have advanced strongly and
financial wealth has escalated. Thus, there is the expectation in the market,
rightly or wrongly, that as a result of the 1987 experience and that of last year,
that faulty investments will be bailed out by the central bank.
Political support for such an asymmetrical monetary policy approach is growing
in the United States. Households have a new profound interest in the success of
the stock market. Now that they are perceived as directly strengthening their net
worth and therefor oppose any monetary tightening that could keep them from
enjoying those rewards. In contrast, years ago households put most of their
savings in simple bank deposits and thus many risk-averse people, especially
among the elderly, actually had a preference for higher interest rates.
Businesses never favor anything that will restrain their sales or their profits. And,
in recent times, those on both ends of the political spectrum have developed an
antagonism to prudence in the pursuit of monetary and financial policy. No
matter how the Fed responds to the bubbling in the market from here on, one
thing is clear to me, it has missed its timing. A bubble is already very big and
there has been a Fed failure to understand and to recognize the significance of
the bubbling for economic and financial behavior. Alan Greenspan indicated that
the Fed must know more about the interaction between the changes in financial
asset values and the economy, back in his presentation at the Jackson Hole
conference last month. And I sat there listening to his presentation very carefully.
He also intimated that once a bubble bursts, the Fed has the capacity to deal
with it. Nevertheless, I believe the response by the Fed to a busting of the bubble
is a very difficult judgement call. If the market responds to an easing of policy,
and rallies again, as it did, for example, last year, excesses in the financial
markets are upheld and a bigger bubble is surely likely to emerge.
On the other hand, the Fed may hope that just a modest deflation of the bubble
will allow economic performance over time to catch up with the overvalued
financial assets at the present. That would be quite an achievement in markets
which today have a very near-term, short-term orientation. Unfortunately, when
you miss your timing, whether it is in personal, in business or in financial life,
there?s always a cost to bear. When official policy, when monetary policy misses
its timing, we all have to share that cost." |
