The Fed as Cheerleader

Has the Fed under Alan Greenspan been so sanguine about the US economy’s potential problems that its behavior verges on the irresponsible? Some economists think so, and their voices seem to be getting louder. For years now Paul Krugman has written that he thinks Greenspan is more of a cheerleader for the Bush administration than a responsible, neutral arbiter of monetary policy. Recently The Economist (subscription required for this piece) has also expressed worries about the Fed:

[T]op officials at America’s Federal Reserve appear quite relaxed about the country’s current-account deficit, just as it hits a new record… Central bankers are paid to worry. Perhaps America’s need to worry a little more.

But the most striking critique came yesterday, with Stephen Roach’s scathing discourse on how the Fed has abandoned its job of keeping over-optimism in check:

In all my years in this business, never before have I seen a central bank attempt to spin the debate as America’s Federal Reserve has over the past six or seven years. From the New Paradigm mantra of the late 1990s to today’s new theories of the current-account adjustment, the US central bank has led the charge in attempting to rewrite conventional macroeconomics… I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind…

The Fed… has also become the intellectual architect of the New Macro. Time and again, since Alan Greenspan rolled out his New Paradigm theory in the late 1990s, senior Federal Reserve policy makers have taken the lead role as proselytizers of a new macro spin that condones the saving, debt, property bubble, and current-account excesses of the Asset Economy.

…Is this is an appropriate role for a central bank? In my view, absolutely not. The problem with an activist central bank is that decision makers in the real economy — consumers and businesspeople alike — mistake the Fed’s point of view for strategic advice. And so do financial market participants.

Whether or not you agree with Roach’s warnings that the US economy is a “House of Cards” poised to collapse, he raises an interesting point: to what degree has the Fed abdicated the traditional central bank role as the economy’s leading proponent of conservative economic behavior? And to what degree does it matter?

I do share some of Roach’s concerns about this, though not as dramatically as he does. The Greenspan Fed has been a surprisingly (to me, anyway) strong proponent of the “Optimistic View” (OV) of the US economy. In the 1990s the OV held that the “new economy” meant that everything was going to be okay, even if share prices rose bizarrely high and savings rates dropped very low. Today the OV holds that rapidly rising household debt is no problem, there is no housing bubble, and the current account deficit is nothing to worry about.

According to the most direct measure of central bank performance, inflation, these embraces of the OV have done no harm – inflation has stayed well under control through it all. The Fed’s reassurances that inflation was not an incipient problem in the late 1990s were quite correct, for example.

But I think most economists would agree that the OV has never been self-evidently correct, and thus could have been (or be) wrong. Even if the Fed’s complacency about potential problems for the US turns out to be entirely justified, I wonder if it is appropriate for a central bank to give such intellectual support to the OV. One problem is something Roach points out – the Fed’s endorsement of the OV may create moral hazard and encourage more risk-taking behavior than would normally take place.

But another problem is simply that the Fed has been staking out somewhat controversial opinions that say that the old rules of macroeconomics are wrong and new rules apply. What if they’re wrong? If it turns out that the Fed’s OV about current financial abnormalities was wrong, then serious financial and inflationary problems could be in store for the US. It could then take many years (or in Roach’s case, probably decades) to repair its credibility as an institution that has a solid understanding of the macroeconomy, and therefore a solid control over inflation.

Credibility is the single most important asset that any central bank possesses, and is one that is very painful to earn. The probability of such a damaging blow to Fed credibility is probably low… but the cost would be extremely high, and thus for an inherently conservative institution like a central bank, the risk may well be worth avoiding. On the other hand, what harm would be done if the Fed remained agnostic on whether the OV is warranted? What harm would be done if the Fed did not actively try to promote the opinion that the US CA balance is nothing to worry about? It’s hard for me to see any.