Why Neel Kashkari was wrong to dissent

In his lengthy explanation on why he dissented from the recent decision of the Federal Reserve Open Market Committee to raise interest rates, Neel Kashkari (NK) of the Minneapolis Federal Reserve had dedicated 2 and 2/3 lines for financial stability because he is dismissive about it. Pity.

The truth is that the Federal Reserve ignores financial stability considerations for a long time. Then, when they tighten, they do so actually for those reasons only. But, they cannot and they will not say it. They remember the ‘lynching’ that Greenspan got for his remarks on irrational exuberance.

They have to explain their actions in the conventional employment-output-inflation framework. But, when these data do not justify a rate increase, then you get these long-winded critiques as NK has done.

However, the problem is that when the Federal Reserve does tighten for (unstated) financial stability considerations (asset price and credit booms), it is usually too little too late. The bubble bursts and the Federal Reserve is blamed for it! The bubble would have burst anyway because it has become too ripe for bursting.

What happens is that, for the next cycle, the Federal Reserve becomes even more defensive. Thus, the problem gets progressively worse and, one day, we will have a meltdown that is impossible to fix.

(1) If the central bank did not want to pop bubbles because they did not know if there was a bubble or not, then why do they intervene when the markets are down? At least, they should be symmetric in their behaviour. Always, leave it to the market.

(2) If the counter argument to (1) above is that there is a disproportionately big impact on the economy when asset prices decline (compared to when they go up), then check the data. Anna Cieslak and Annette Vissing-Jorgensen (2017) have shown that the sensitivity of the economy to asset price declines is far lower than what the Fed models assume.

Therefore, the task in front of the Federal Reserve is clear. Simply put, first, they have to abandon their fixation with protecting the downside for asset prices, under the mistaken and benign (let us give them the benefit of doubt, on their bona fide) assumption that asset prices for the real economy when they decline.

Second step is to actively incorporate financial stability concerns into their monetary policy framework. It is not just about asset prices, credit growth or stock market volatility or margin trading or derivatives volumes. It could be all of them and something else, every time. So, a judgement is always involved and inevitable. One could go wrong or be early. But, that is an occupational hazard. All monetary policy decisions are judgmental because we are not dealing with physical sciences with their deterministic laws. Pity that Mr. NK is either not aware of these nuances or does not care.

The financial industry — with its political connections — will always protest the loudest that the central banks took away the punch bowl unnecessarily.

But, the 2008 crisis is a very big and powerful argument in their favour to shut the politicians and the financiers up. All that it requires is courage and conviction on the part of regulators and central banks to make that case forcefully and eloquently. Every financial crisis strengthens their hand in dealing with financial stability issues pre-emptively.

If they are still reluctant/unwilling/unable to do so, then we have to think hard about the incentives at work that hold them back. Unfortunately, those incentives do exist. Revolving doors and speaking engagements are realities.

So, who really will bell the cat? Enlightened politicians? Where are they?

As long as the politician can kick the can down the road and hence enjoy the benefits with costs being shifted in time into the future, the question will remain. Time inconsistency is the bane of public policy.

Actions-benefits-costs are neither synchronised nor compressed within one’s relevant horizon.

That is where a spiritual orientation/dharma (Raj Dharma or personal dharma) come into play: “I do it because it is my dharma to do so and because I believe it is the correct thing to do.” But, most politicians and policymakers (P and P) either do not have that orientation or would laugh at it.

A couple of more systemic issues come in the way of the ‘right action’ in the ‘larger interest’ and for the ‘long term’. Besides time inconsistency, there is the ‘spatial’ or the ‘personal inconsistency’ problem.

Confronted with a potential executive action, say a financial regulation, losers can mobilise far more easily than the winners or beneficiaries. They are few and concentrated and have resources.

Far easier for them to incentivise and offer other benefits to P and P not to act than the millions of beneficiaries from the population to mobilise and encourage P and P to act.

That is why, in democracies or in all good governments, there is an expectation that they would act according to certain absolute principles or dharma. There should not be a need for specific mobilisations to induce them to act, on every occasion. That is simply not feasible.

Then, there is the curse of the counterfactual.

It is far easier to act to prevent a visible loss or suffering than to take action to forestall one. The Federal Reserve has been practising it. That is why they intervene after a bubble has burst and there is loss and suffering. It is easy to justify a rate cut or any other action, then. The pain is visible. Hiking rates to forestall a bubble or financial instability is more difficult to justify.

At a personal level too, we see it from the small to the substantive.

Most life-style diseases are silent diseases. That is why humans wake up too late to their downside. Since we do not see their effects visibly and regularly, we do not take action. Much easier to swallow an anti-histamine than to gargle and maintain nasal and throat hygiene when there are no symptoms of cold or sore throat.

To a degree, design of health insurance policies — with rewards in the form of lower premiums — seeks to mitigate or accommodate the curse of the counterfactual. The lower premium is the visible reward that naturally induces (or, nudges) the individual towards desired actions.

But, we are not able to replicate this in all areas and for all decisions. Therefore, these issues will be with us forever.

So, the only GOD we look up to, to change their behaviour, is CRISIS or CRISES! Even better, only bigger and bigger crises are the answers. That is a pity and a tragedy.