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.If option issu-ance had been sensibly reflected in corporate accounts, the run up in cor-porate earnings in years before 1998 would not have been as great as itwas.However, the dramatic fall in the real federal funds rate after 2000 was aFederal Reserve initiative, which may have been in part a response to thecrash in equity markets.It appeared that the FOMC feared the possibilityof a deflationary spiral after the stock bubble burst.As noted above, thelarge fall in interest rates is likely to have contributed to the possible bub-ble in the housing market.Although the FOMC raised the nominal federalfunds target interest rate in 25 basis increments at every meeting betweenJuly 2004 and July 2006, the real federal funds rate continued to be nega-tive through the first half of 2005.Mushrooming federal government defi-cits, associated trade deficits, and a sustained period of near-zero real fed-eral funds rates did not promise a smooth ride in the subsequent years!Low rates did not lead to increased investment in plant and equipment, be-cause capacity utilization rates rose only slowly through 2005 in the U.S.and were not especially high then.34 Utilization rates predictably rose morestrongly in 2006, after the real federal funds rate turned positive, butseemed to reach a plateau in 2007, with only modest domestic net invest-ment in plant and equipment.8.4 What Guidelines for the Federal Reserve Emerge fromThis History?The first and most important guideline is that the Federal Reserve mustavoid adopting inflexible rules when implementing monetary policy.Thisincludes mechanical rules like a constant growth rate of some monetaryaggregate or an inflexible real or nominal interest rate, but it also includesinflexible targeting of nominal GDP, the international value of the dollar,or an inflation rate.Innovations and institutional change require flexibility.Unlike many of his critics, Chairman Greenspan accepted this guideline:Rules by their nature are simple, and when significant and shifting uncertaintiesexist in the economic environment, they cannot substitute for risk-managementparadigms, which are far better suited to policymaking.Were we to introduce34The Federal Reserve s total index of capacity utilization was at a ten-year lowin 2003; at yearend 2005 it was four points below levels achieved in the mid1990s.See http://www.federalreserve.gov/releases/g17/ipdisk/utl_sa.txt.What Guidelines for the Federal Reserve Emerge from This History? 125an interest rate rule, how would we judge the meaning of a rule that posits arate far above or below the current rate?.In summary then, monetary policybased on risk management appears to be the most useful regime by which toconduct policy.The increasingly intricate economic and financial linkages inour global economy, in my judgment, compel such a conclusion.35Discretion rather than rules in no way reduces the need to hold theFOMC fully accountable for its decisions.Accountability requires that fulldisclosure of the reasoning and information underlying it be made publicin a timely fashion.Timely does not necessarily imply immediately, butsurely within a few weeks.Immediate disclosure might create indefensibleopportunities for profit by individuals with low trading costs and relativelyrapid access to markets, and might compromise the technical implementa-tion of policy.The timing and disclosure of policy decisions improvedconsiderably during Greenspan s Chairmanship and has improved furtherunder Chairman Bernanke.Second, while the set of policy instruments available to the FOMC hasbeen depleted in the recent decades, open-market operations, moral sua-sion, discount rate changes, and timely revisions of regulations are likelyto be borderline sufficient to achieve maximal sustainable growth with lowinflation.As noted above, there are good reasons to believe the potency ofreal interest rate changes has increased.Because of large internationalholdings of dollars, the Federal Reserve should attempt to coordinate pol-icy with foreign central banks to vary real interest rates constructively.Failure to coordinate would not be catastrophic, but it could lead to largerrequired changes in real interest rates that might have destabilizing side ef-fects.Moral suasion is needed to reinforce policy initiatives and to conveywhat the FOMC is trying to achieve.New regulations are likely to be needed and existing regulations con-tinuingly revised in order to preserve the integrity of markets that are beingbuffeted by innovations.Many innovations are designed to avoid bindingbank capital constraints; often they take the form of designer derivatives,asset sales, and remote-financing vehicles, as is explained in Chapters 7and 10.Because innovations often occur in capital markets, the regulationsneed to come from the U.S.Securities and Exchange Commission and theU.S.Commodity Futures Trading Board, as well as from the Federal Re-serve Board.At present these agencies seem to be more concerned withpreserving their turf than with coordinating regulatory policies.Additionalinformation about the composition of assets behind asset-backed securitiesand tighter covenant specifications on loans and securities are needed to35Greenspan (2003).126 Overview and Summary of Part 1avoid instability, such as seemed to be resulting from sub-prime, mort-gage-backed securities in 2007.36One proposal I suggest for improving accountability and the functioningof security markets is to reestablish formally a mechanism that worked inthe 16th Century.Commercial bills in Amsterdam were often tradedamong merchants and investors and used to settle accounts.Whenever abill was traded, the purchaser added his name to the back of the bill andbecame potentially liable for a default.When the bill matured, the issuerwas obligated to pay the holder the principal and interest.If the issuercould not, then the next signer became responsible for paying the holder.This mechanism, holder in due course , served to make each purchasercarefully evaluate the financial condition of the individual offering to sell abill.A modern appearance of this mechanism occurred in May 1982 whenthe Chase Manhattan Corporation agreed to pay for losses associated withrepurchase agreements that it had arranged for a small securities firm,Drysdale Government Securities, Inc.Chase Manhattan agreed to pay$270 million, when Drysdale defaulted on its obligations to creditors, be-cause it was interpreted to have acted as a principal rather than as an agentfor Drysdale.37 Chase never accepted the legal interpretation that it was li-able as a holder in due course, but it paid
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