Academic journal article The Cato Journal

Thinking Ahead of the Next Big Crash

Academic journal article The Cato Journal

Thinking Ahead of the Next Big Crash

Article excerpt

In the aftermath of the unprecedented 2008 financial crisis, researchers of macroeconomics, finance, and political economy are showing renewed interest in the old but very significant question: Are central banks in large reserve currency democracies--in particular, the U.S. Federal Reserve--prone to creating asset bubbles and, if so, how is it possible to prevent the misuse of the banks' discretionary powers?

If one searched for guidance in the relevant literature, one would come across three main strands of thinking. The oldest stems from the views classical economists held and is expressed in the following slump criticism that David Ricardo (1809: III, 21-22) addressed to the Bank of England for the way it managed the quantity of banknotes:

   By lessening the value of the property of so many persons, and that
   in any degree they pleased, it appeared to me that the Bank might
   involve many thousands in ruin. I wished, therefore, to call the
   attention of the public to the very dangerous power with which that
   body was entrusted; but I did not apprehend, any more than your
   correspondent, the signature of "A Friend to Bank Notes," that the
   issues of the Bank would involve us in the dangers of national

Ricardo was concerned that the Bank of England violated the principle of price stability and, by doing so, risked ruining many people and driving Britain to bankruptcy. Notice though that Ricardo did not appeal to experts for devising mechanisms to tame the power of the central bank, as specialized economists are doing in our times. He appealed to the public--the ultimate source of power in democracies--by stressing that if central banks are left unchecked, they have too much power and may use it with devastating consequences for the citizens and their countries.

The 2008 events in the United States affirmed once again the time-honored truth of Ricardo's intuition that controlling the power of central banks is an issue of political economy rather than monetary engineering, and it is precisely this realization that motivates the present article.

The second strand of thinking emanates from the Austrian theory of the business cycles that Ludwig von Mises (1936) and Friedrich A. Hayek (1939) proposed. (1) For them, there was no doubt that ruinous bubbles are always ignited and propagated by central banks. The sequence of events they envisioned starts with an increase in the quantity of money issued by the central bank. This, in turn, lowers the nominal interest rate below the rate that would be set by the time preferences of savers. Responding to the lower interest rate, entrepreneurs create a boom by reallocating investment toward long-lived and away from short-lived capital goods, because the former become more profitable than the latter. But since the time preferences of savers remain unchanged, the demand for the output of long-lived assets grows gradually short of its supply, and eventually it becomes clear that capital has been misallocated. The greater the monetary expansion, the longer the boom and the more serious the misallocation of capital becomes. Thus, there comes a time when suddenly a recession, or depression, breaks open and leads to liquidation not only of the inefficient and unprofitable businesses but also of the speculative investments in all sorts of financial stocks, bonds, and real estate. This theory explains what happened in the United States in 2008 quite well. But before looking into this issue in detail, a reference to the third strand of thinking is necessary.

This can be inferred from the analytical approach suggested by Adam Posen (2011) and presumes that it is impossible to say whether central banks create bubbles or not, because there is the following fundamental problem of knowledge. For central banks to self-control against creating bubbles, they must be able to: (1) identify precisely the relationship between the quantity of money and current prices, as well as prices that would be warranted by the fundamentals in key sectors in the economy; (2) construct reliable indicators that will warn sufficiently ahead which misalignments between these two sets of prices are dangerous; and (3) develop instruments that will permit quick and effective interventions whenever dangerous misalignments grow beyond certain safe limits. …

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