To Lean, Clean, or Reign Supreme
In the early 2000s, before the financial crisis, a debate dominated central banking: whether central bankers should try to rein in financial bubbles in what was called “lean against the wind.” That is, over and above their macroeconomic targets – keeping inflation at or around 2% and ensuring full employment – central banks should also take financial market manias into account. Since spillover from a financial debacle can greatly impact what us economists call the “real” economy (i.e., outside the financial sector), maybe positioning monetary policy accordingly could prevent the crisis altogether – or make the bursting of a bubble less painful.
When stock market valuations or house prices were high and speculation ran rampant, the story goes, central bankers should lean against that by raising interest rates and making debt-fueled speculation a little more expensive. If done skillfully and with good timing, central banks could prick bubbles before they got out of control, at minimum cost to the real economy. In theory, anyway.
The debate at the end of what economists call the Great Moderation (a time roughly between the 1980s and 2007 characterized by low inflation, stable unemployment, decent economic growth and only mild recessions), most central banks had landed in the “don’t lean” camp. It’s hard to spot a bubble, it’s costly to the economy to run with above-optimal interest rates, and the few recessions they encountered taught them that “cleaning up” after an implosion – flushing the banking system with liquidity – was cheap and easy.
The financial crisis of 2007/8 was a painful wakeup call for this established intellectual consensus. The Global Financial Crisis, or GFC, was not easy to clean up; it caused a lot of pain; it was followed by years and years of sluggish growth. Its effects are still with us in terms of home-ownership ratios, government debt, people out of the labor force, and the size of the central bank’s balance sheet. With the eurozone crisis, insolvent governments in Europe’s periphery, and catastrophic economic performance even a decade later, most economists looking at the European Central Bank’s troubles quickly changed their minds. Christian Drescher at the German Bundesbank wrote that however unpleasant and inappropriate it may be to lean, it is “better to lean against the wind than to fight a hurricane.”
Drescher aptly summarized the debate to turn on the following questions:
- Identification/Information: It is far from obvious that anyone can reliably spot asset bubbles, let alone that central bankers can do so better than market participants, to which leaners responded that central banks have private regulatory information and can see the bigger picture;
- Destabilization: by pricking a bubble, you may cause panic, perverse incentives, and other unwanted market behavior. The leaners’ suggested solution was to prick a bubble only at an early stage (but that places even higher information demands on the central banker, as per above);
- Costs: leaning causes “collateral damage” to the rest of the economy for reasons that, even if the central banker is correct (a big if) are going to look dubious to outsiders and policymakers (if you think it’s easy to convince others that your stern actions prevented something that didn’t happen, I have a pink-elephant repellant to sell you). Leaners objected that financial crises are much costlier than that minor damage.
- Effectiveness: central banks have few precision tools at their disposal (shift in the money supply and interest rates hit everywhere in the economy) whereas leaners think they have outsized effects on bubble participants.
These aren’t trivial problems. While quacks, anticapitalists, and those viewing history in hindsight confidently pronounce that they could spot a collapsing bubble before it happened, the evidence is much less convincing. We can use words and feel uneasy about the quick rise in some asset’s price but words and feelings are poor guides for something as important as an economy-wide monetary policy.
In 2015, even Markus Brunnermeier, a long-time scholar of bubbles, and Isabel Schnabel, then professor of financial economics at the University of Mainz and now on the ECB’s executive board, did not mince words in their extensive survey of historical bubbles and monetary policy:
“First, bubbles cannot be identified with confidence. A deviation from the fundamental value of an asset could be detected only if the asset’s fundamental value was known.”
Policies that try to identify them and deflate them have “serious impediments,” the scholars conclude.
What I often found odd in the argument was the hubris to presume that investors, asset managers, or households involved in a bubble would be much swayed by the central bank pushing up the Fed funds rate by a percentage point or two. If leaning works, it works by squeezing the least profitable firms in the economy and liquidating the least solvent and/or convinced investors in the mania. Serious bubbles promise lush and excessive returns in the tens or hundreds of percent – that’s the grand promises that leaning must rein in.
Fast-forward to today, there is an eerie consensus that something is off in financial markets and money more broadly. The GameStop debacle earlier this year was but a preview of what was brewing: retail investors, cheered on by TikTok videos, Reddit forums, and “the boredom hypothesis,” are throwing unfathomable amounts of money around various degrees of hopeful garbage – renewable energy firms, SPACs, dogecoin, colorful options on Robinhood, electric vehicle producers, and every commodity under the sun. Jemima Kelly in the Financial Times concludes that it is “hard to make sense of financial markets in 2021.”
On to the scene we have an op-ed in the Wall Street Journal on Monday, by Christian Broda and Stanley Druckenmiller, two well-established investors, resurrecting this never-ending debate over what central banks ought to do:
“Fed policy has enabled financial-market excesses. Today’s high stock-market valuations, the crypto craze, and the frenzy over special-purpose acquisition companies, or SPACs, are just a few examples of the response to the Fed’s aggressive policies. The central bank should balance rather than fuel asset prices.
The long-term risks from asset bubbles and fiscal dominance dwarf the short-term risk of putting the brakes on a booming economy in 2022.”
After a decade or more of economic and financial events that put central banks under heavy strain – financial collapse, a slow and timid recovery, the pandemic – strange things are again amiss in financial markets.
Broda and Druckenmiller are right to say that “the Fed seems to be fighting the last battle.” Ironically, so are they: we’re back in the lean-or-clean debate of twenty years ago.
This article was published on May 16, 2021 and is reproduced with permission from AIER, American Institute for Economic Research
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