Nobel Prize winning economist Vernon Smith says the question is, how do you achieve just a bit without getting too much?

Question: What are the constraints on the Fed that prevent it from moving beyond its typical role as inflation fighter to address employment, another key part of its mission? (Ryan Avent, The Economist)

Vernon Smith:  Well the Fed has already I think taken actions in roughly the last year. The excess reserves have risen by about a trillion dollars and that has huge inflationary potential depending upon what kind of endgame strategy the Fed follows in getting us out of this huge potential expansion in credit in the private economy.  Of course it’s not been a problem because those excess reserves have not led to any kind of undesirable credit expansion in the private economy because there is just no demand for loans right now. The reason my coauthor Steve Gjerstad and I said that some inflation might be a good thing at the present time is that it is one way to get the relative price of homes up.  If you inflate basically the rest of the economy by 6 percent then you correct that imbalance between the price of homes, which have gone way up during the boom went way up out of proportion to other prices in the economy, so it’s important for the relative price of homes now to come back to more standard historical levels if you’re going to get a natural resumption in the demand for housing.  And of course the problem in setting about and creating a 6 percent inflation rate to give you that relative price change is simply that you might not be able to control those forces once they’re unleashed, so in a way our recommendation is somewhat tongue and cheek.  I think that a little inflation now would be a good thing.  Yes, it would, but the question is how do you achieve just a little bit of inflation and not get too much. 

Question: One of the problems with TARP was an inability of the treasury to come up with an auction design that would correctly reveal the value of the toxic assets and fear of overpaying led them to be cautious to the point of never actually implementing the program to any significant degree.  Is there any way to design an alternative market mechanism that will value these assets next time?  (Mark Thoma, Economist’s View)

Vernon Smith:  I really can’t answer that.  It would require a pretty extensive experimental examination of the issues here to really come up with the question of whether you could design an auction for the treasury to dispose of these toxic assets.  You know the problem people have described it as just a reverse auction where instead of the treasury being a seller of treasury securities as they have had a lot of experience with. See, the treasury sales securities to multiple buyers in treasury auctions and here you have the treasury buying from multiple sellers of these toxic assets, but the problem is that these assets are not homogeneous.  When the treasury is issuing securities to multiple buyers there isn’t any difference. Every one of these securities is exactly like every other one, so that the buyers do not have the problem of valuing a mix of heterogeneous items.  It’s a homogeneous set of items that are being offered up for sale.  Private auctions don’t have any difficulty valuing heterogeneous assets.  What they do is put them up to for sale one at a time.  If you got to Christie’s or Sotheby’s, the auction houses, they auction items, heterogeneous items either singly or in very maybe very small groupings that are relatively homogeneous and if you’re going to do a multiple unit auction of dissimilar items that’s a challenging problem and the whole…  You know the original proposal didn’t make any sense to me and of course they quickly found out what I think is obvious, which is that the treasury is simply not practiced at all in running  that kind of auction and they backed off to as well they should have.

Recorded on December 15, 2009