Preventing Bubbles: Regulation versus Monetary Policy

November 17, 2011

U.S. monetary policy, usually related to the Federal Reserve's indifference to the value of the dollar, has repeatedly caused harmful asset bubbles in the United States and abroad.  Policy is again at risk with the Fed's imposition of near-zero interest rates and its decision to conduct large-scale asset purchases (termed "quantitative easing").  Regulatory policy has often been ineffective at identifying or addressing asset bubbles (especially those caused by Fed policy), so reforms should be considered that will help realign Fed's actions with national good, says David Malpass, President of Encima Global LLC.

  • First, the Fed should restrain its preference for an absolutely free-floating exchange rate, as this embraces a highly cyclical economy of regular booms and busts. Instead, the Fed should value and uphold a strong and stable dollar.
  • Second, limit the current tendency of the Fed to enlarge its balance sheet at an out-of-control pace (it is currently expanding at an average rate of $75 billion per month due to quantitative easing purchases).
  • Third, the Fed should reassess its interest rate structure. Currently it is overpaying for excess reserves by maintaining a 0.25 percent interest rate. This should be lowered to 0.15 to encourage banks to lend in private markets. Additionally, the Fed should attempt to reach an agreement with banks to lower their prime rate. Finally, the Fed should gradually raise the Fed funds rate to 1 percent and continue to raise it further after that, paying close attention to dollar stability.
  • Fourth, the Fed ought to hold in reserve some of its profits in the long run in order to create a reserve of its own.

These reforms will help the Fed to limit its negative impacts on developing nations and the creation of bubbles.  And in accomplishing this end, regulatory policy would be better able to identify and address the market flaws causing asset price aberrations.

Source: David Malpass, "Preventing Bubbles: Regulation versus Monetary Policy," Cato Journal, Fall 2011.

For text:

http://www.cato.org/pubs/journal/cj31n3/cj31n3-11.pdf

 

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