Otherwise known as The Crunch. Apparently, an ‘adverse feedback loop’ is where financial disruptions cause investment and consumer spending to decline – and it is incumbent on the monetary authorities to move very quickly when one looks like developing.
So says Frederic Mishkin, the newest Federal Reserve governor, who was a Columbia economist before joining the Fed in September.
Han de Jong, ABN Amro’s chief economist, has been leafing through Mr Mishkin’s recent speeches since the ABN man believes this particular Fed governor provides valuable evidence as to the thinking of Ben Bernanke, the Fed chairman. Says de Jong in his latest missive to clients:
Mishkin and Fed chairman Ben Bernanke go back a long way. Both were graduate students at MIT. As academics, they worked together on research projects, focusing on central banking. One must assume that Mishkin and Bernanke work together very closely at the Fed and that Mishkin will not say things in public that Bernanke is unaware of or clearly disagrees with. From an academic and intellectual point of view, Mishkin must be considered a heavyweight Fed governor when it comes to monetary policy.
So what has de Jong learned? That US interest rates are coming down further – and quickly:
Frederic Mishkin is currently perhaps the most influential Fed governor. He argues in favour of what could best be described as aggressive monetary easing when financial instability is threatening to have a negative effect on the real economy, which might in turn aggravate financial instability. Mishkin rejects suggestions that such action could lead to moral hazard. In his opinion, the Fed needs to act in a timely, decisive and flexible manner. It needs to get ahead of the curve. Judging by developments in the real economy, financial markets and lending practices among banks, it cannot be argued that the Fed is already ahead of the curve. Only further, possibly aggressive, rate cuts will take it there.
It seems that Mishkin takes a theoretical but easy-to-understand approach to financial instability, which he argues is caused by problems in the flow of information.
Mishkin explains the role information plays in financial instability thus: “During periods of financial distress, information flows may be disrupted”. He adds: “A period of financial instability arises when a shock to the financial system prevents it from channelling funds efficiently to productive uses; as I will describe, such a shock generally relates to problems in the flow of information…”
He then argues that two types of risks are particularly important in this situation. The first is valuation risk. This is the uncertainty in establishing the value of an asset. The second risk is macroeconomic risk, which he describes as the “probability that a financial disruption will cause a significant deterioration in the real economy”.
Mishkin’s next step is very important: the two risks are not independent of each other. Economic downturns make it even more difficult to value assets properly. This leads to further problems in the extension of credit as financial institutions suffer losses and, also because of the uncertainty, become more reluctant to extend credit. This, in turn, damages the real economy further. This develops into an “adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline”.
Read the ABN man’s full commentary here.