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Greenspan's big experiment
US economic performance over the next few years will show whether asset prices should be included in inflation targeting
"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged corrections?"
Shortly before Alan Greenspan, chairman of the US Federal Reserve, asked this excellent question, on December 5 1996, the Dow Jones Industrial Average reached 6,500. Subsequently, it rose to more than 11,000, before its recent correction. That climb can only increase the worry.
The attention to be paid to asset prices is the most fiercely debated topic in monetary policy. This is so for two reasons, one general and one specific. The general reason is that excessive asset prices have helped cause soaring expansions and deep recessions in so many countries, not least Japan. The specific reason is what is happening in the US.
The world's most important economy suffers from many of the symptoms of asset price overvaluation: unprecedented equity valuations; a private sector financial deficit of more than 5.5 per cent of gross domestic product; a soaring current account deficit; and a sustained rise in the ratio of private sector indebtedness to income.
What would happen if the US were to go the way of the others? The answer, suggest Bill Martin and Wynne Godley in a recent paper for London-based Phillips & Drew, is at best a long period of stagnation. This gloomy view is hotly contested. Yet it is little wonder that Mr Greenspan returned to the conundrum at this August's Jackson Hole symposium of central bankers. "We no longer have the luxury to look primarily to the flow of goods and services . . . when evaluating the macroeconomic environment," he remarked. "There are important - but extremely difficult - questions surrounding the behaviour of asset prices and the implications of this behaviour for the decisions of households and businesses."
What then should central banks do in response to movements in asset prices? There are two broad options: they can target these prices or they can take them into account when setting not just monetary policy but also prudential regulations.
The theoretical argument for including asset prices in the inflation target is that movements in their prices are themselves inflation. The argument - first advanced by two American economists, Armen Alchian and Benjamin Klein, in an article published in 1973 - is that a proper measure of inflation would include prices of future goods and services. Such prices are best captured in the current prices of the assets that give command over future consumption. In a recent article, John Flemming, a former chief economist of the Bank of England and the European Bank for Reconstruction and Development, suggests that changes in the dividend (or earnings) yield on pension fund assets could be employed as a measure of this form of inflation. This argument is theoretically correct, but practically close to inoperable. Even Charles Goodhart, a member of the Bank of England's monetary policy committee who is persuaded of the validity of the argument, agrees. "As a practical matter," he argues, "it will continue to be so problematical to take account of asset price changes in any measures of inflation that we will rightly go on concentrating on present current cost, consumer price and retail price indices. "If one had any doubt about the difficulty, one needs only look at the actual behaviour of asset prices shown in the chart. They are too unstable to target closely.
Yet if asset prices cannot be included in the inflation target, they cannot be ignored either. Policymakers must take them into account.
In the first place, they must look at them for prudential reasons. When asset prices soar, collateral is more valuable and borrowing tends to explode. This is particularly true when it is property prices that rise. Experience demonstrates that a subsequent price collapse renders many borrowers bankrupt and can destroy the solvency of lending institutions. In extreme cases, such "debt-deflation" imposes huge damage on the economy.
Mr Greenspan himself raised the worry in a speech on October 14. He argued: "The uncertainties inherent in valuations of assets and the potential for abrupt changes in perceptions of those uncertainties clearly must be adjudged by risk managers at banks and other financial intermediaries." In other words, watch out.
Yet such warnings are hardly enough. Given the impact of these mistakes on innocent bystanders, often including taxpayers, the regulators should be tightening capital requirements when asset prices are soaring and credit is easy.
The idea may sound interventionist. But all governments regulate their core financial systems, for good reason. Such leaning against the asset price wind seems mere commonsense.
In the second place, asset prices should be taken into account as indicators of the monetary stance and as a force bearing on activity. In a paper presented at the Jackson Hole symposium, Ben Bernanke, of Princeton university, and Mark Gertler, of New York university, argued that the right answer is "flexible inflation targeting". A central advantage of the inflation-targeting framework is, they assert, that it automatically induces policymakers to adjust interest rates in a stabilising direction in the face of asset-price instability or other financial disturbances.
Their conclusion, however, that the right regime is forward-looking targeting of inflation, combined with strong financial regulation, is still problematic. One worry is that central bankers will find themselves caught up in the euphoria and so fail to curb excessive growth in demand.
Yet central bankers may be doing still worse than that. Mr Greenspan's focus at Jackson Hole was not on bubbles, but on "sharp reversals of confidence" - crashes, in other words. Yet his demonstrated willingness to respond to sudden falls in asset prices, and to the consequent drying up of liquidity, insures investors against the risk of being trapped in a collapsing market. If so, he and his peers help create the unsustainable prices whose destabilising consequences they fear.
It may not be sensible to target asset prices directly. But it does make sense to lean against the asset-price wind, through forward-looking inflation targeting. Anti-cyclical prudential regulation also merits serious examination.
Yet in the last resort, the consensus is almost certain to depend on what happens in the US economy over the next few years. Today's surging US economy has become a policy experiment of historic importance. |
