The Insane Impulse to Fight Bubbles by Causing Recessions and Mass Unemployment

Federal Reserve governor Jeremy Stein is one of these people who entered the realm of public service with a very high reputation among his academic colleagues, so ever since he started delivering speeches (PDF) in favor of the ridiculous idea that central banks should sometimes implement monetary policy that’s inappropriate to employment and inflation conditions for the sake of “financial stability,” people have been treating it with a lot of respect.

But there are already lots of smart, respectful replies out there. So let’s just say clearly: This is nuts. The purpose of monetary policy is to stabilize employment and inflation conditions, and central banks should do that. If full employment exists and inflation is low and stable, then you should not deliberately engineer a recession for the sake of financial stability. If unemployment is high and inflation is low and below target, then you should not deliberately prolong the bad labor market for the sake of financial stability.

Why not? Honestly, I barely think we even need to give a reason why not.

The question is why would you do this? And the answer would have to be that you have exhausted every other tool in your regulatory arsenal to curb the alleged bubble, and having done so you’re not so desperate that you’re prepared to contemplate the obviously ridiculous idea of deliberately engineering a recession. After all, think back to 2005. Imagine someone saying “man, there’s some crazy stuff going down in mortgage finance and the larger banking sector, we really need to crack down on it with Regulation X.” What’s the counterargument to Regulation X going to be? Well, it’s going to be the same counterargument that gets made to every proposed regulation in any subject area—it’ll cost jobs and hurt growth. And that’s certainly something to think about. But do you know what will definitely cost jobs and hurt growth? Deliberately engineering a recession with excessively tight monetary policy. Just do the regulation instead!

An analogy to environmental regulation might be useful. It turns out that crippling recession and mass unemployment curb carbon dioxide emissions. Climate change is also a serious problem. So should we deliberately engineer long and severe recessions to curb carbon dioxide emissions? Obviously not. Even though it would work, it’s clearly the worst possible way to achieve the goal. There is an endless list of tax and regulatory measures that can curb air pollution in a less harmful way than deliberate recession creation, and financial stability is no different.