January/February 2013

Bubbles, Crashes, and Rules at the 30th Annual Monetary Conference

“All those who wish to stop the drift toward increased government control should concentrate their effort on monetary policy,” F. A. Hayek once said. At no time since the founding of the Federal Reserve nearly a century ago has it been more important to reconsider the policy steps needed to avoid future financial crises. At the Cato Institute’s 30th Annual Monetary Conference, experts came together to examine the links between sound money, free markets, and limited government — and focus in particular on how those links might evolve in the years ahead.

The conference, “Money, Markets, and Government: The Next 30 Years,” was directed by Cato vice president for academic affairs James A. Dorn. In addressing the limits of monetary policy, scholars discussed how the choice between alternative regimes will determine whether economic harmony will spontaneously emerge or government power will continue to grow.

In his keynote address, Nobel laureate Vernon L. Smith discussed the history of bubbles, focusing in particular on the similarities between those that preceded both the Great Recession and the Great Depression in the United States. In both cases, “the imbalance was fueled by outsized mortgage credit expansion,” Smith argued, adding that there are three fundamental responses to such balance sheet crunches, each of which he detailed in full.

Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, began his panel by asking whether we are sowing the seeds for the next financial crisis. This, he said, was likely. “Incentives matter,” Hoenig explained, “and the incentives toward risk among the largest financial firms remain basically unchanged from pre-crisis times.” Jeffrey A. Miron, senior fellow at the Cato Institute and director of undergraduate studies in economics at Harvard University, followed by asking a different question: Should we try to avoid the next crisis? “If policymakers focus on this as their goal, they’re going to adopt policies that typically fail to avoid crises and are counterproductive from a long-term perspective,” Miron argued. The treatment, he said, is almost certainly worse than the disease.

John B. Taylor, professor of economics at Stanford University, focused on the past 30 years of monetary policy and what that history indicates for the next several decades. “The most important thing that we can do is find a way for monetary policy to get back to a rules-based strategy,” he concluded. Other speakers included George S. Tavlas, director of the Bank of Greece; Jürgen Stark, former chief economist of the European Central Bank; Eswar S. Prasad of Cornell University; and Gerald P. O’Driscoll Jr., senior fellow at the Cato Institute.

In his closing address, Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia, unpacked the “extraordinary actions” taken by the Fed as of late. He argued in favor of pursuing a systematic approach instead, centered on using “robust simple rules” as a guide to the Fed’s policy decisionmaking process. “Excessive focus on the short term can result in long-term problems,” he warned. “Avoiding these risks is dependent on the Fed executing a graceful exit from this period of extraordinary accommodation.”