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Federal Reserve governor Kevin Warsh, in a speech in Atlanta today, offered four lessons he draws from the recent crisis. Here's an excerpt:
First, don't blame the mirror. In times of economic weakness or financial distress, policymakers are often troubled by the messages embedded in financial market prices or bank lending statistics. Some supervisors might disagree — even strongly — with the prices markets assign to a banking system's financial wherewithal. Some elected officials may blame commercial banks for the low levels of lending. Some out-of-favor fiscal authorities may take great umbrage at the prices assigned to their funding costs. Still, outlawing a class of securities or upbraiding an industry tends to be counterproductive.
Second, don't fall in love with the mirror. In benign economic times, market prices can lull investors and policymakers into a false sense of security. Financial market prices may appear more sanguine about prospects than fundamentals suggest. The cost of issuing a 10-year Treasury bond or German bund might be exceptionally low by historical standards. Inflation expectations may appear well anchored. But this is no guarantee of future performance. Market prices adjust slowly and steadily?until they don't. Then, market prices can act in a nonlinear fashion. That's when policymakers end up with fewer, less desirable options?.[T]hink of the financial markets as a mirror, a very imperfect but still telling reflection of reality.
Third, facts, not force, should be the predominant policy response. Prevailing wisdom has it that policymakers must overreact when markets do. In my view, this is an uncertain proposition. If a problem were unique or isolated, game theory suggests that overwhelming force might serve policymakers' interests. But, these problems are not isolated. And it is no game. Markets will continue to clamor for more explicit government commitments. Better to feed the proverbial beast with more facts than force. The Federal Reserve-led stress tests are but one example where the balance was reasonably struck.
Fourth, there are no free lunches, but there is an early-bird special for dinner. Economic trends — fiscal, monetary, trade , or regulatory — tend not to improve when the immediate is continually given preference over the important. The economy's long-term growth prospects must be given top billing. As [Brookings Institution and adviser to President Jimmy Carter] economist Charles Schultze reminded us, it is not the wolf at the door but the termites in the walls that require attention. The sooner the house's structure is strengthened, the better.
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Fifth, don’t assume that this one’s over!
Real Time Economics offers exclusive news, analysis and commentary on the economy, Federal Reserve policy and economics. The Wall Street Journal’s Phil Izzo and Sudeep Reddy are the lead writers, with contributions from other Journal reporters and editors. Send news items, comments and questions to realtimeeconomics@wsj.com.
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