Sunday, September 02, 2007

The Asymmetries of Chairman Bernake

Ben Bernake's academic work is all about limiting monetary policy to restraining price inflation. Asset prices aren't supposed to matter. And that theory has had practical consequences: through all the worries about housing and stock market bubbles, the Fed has refused to raise rates unless these phenomena fed into price inflation. Not surprisingly, housing and stock market bubbles have resulted.

But in the wake of the subprime crisis, it now appears that the Fed will lower rates to avoid a collapse of the housing market. According to the FInancial Times:

Federal Reserve governor Frederic Mishkin set the stage for an aggressive monetary policy response by the US central bank to any fall in house prices in his presentation to the Jackson Hole symposium this weekend.

Mr Mishkin told fellow central bankers and top economists gathered for the annual retreat organised by the Kansas City Fed that policymakers should not wait until a decline in house prices leads to a fall in gross domestic product, but should “react immediately to the house price decline when they see it”.

The problem with this approach is that it is asymmetrical. Losses are bailed out: gains are not similarly curtailed. This creates a "moral hazard": the rational investor will take more risks on the upside if the downside is insured. The predictible consequence is more bubbles and more bailing out of the risk takers at the expense of those holding money.

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