Sept. 23 (Bloomberg) -- In an effort to determine what went wrong and enshrine “never again” as their motto, central bankers are focusing on what they did, or didn’t do, in their role as regulators to aid and abet the financial crisis.

The Federal Reserve, for example, in its capacity as a bank supervisor, plans to get involved in the compensation of bank employees, from chief executive down to loan officer.

It’s not as if policy makers presume to know the right pay scale for the third assistant V.P. in charge of lending to small- and medium-sized companies. It’s that they want to make sure incentives don’t encourage excessive risk-taking in pursuit of short-term profits.

What happened to the role monetary policy played in the crisis?

Asked about such a rethink following a speech to the New York Economic Club last October, Fed chief Ben Bernanke hinted he was looking at the role of both interest rates and regulation in the creation of asset bubbles. Since then, interest-rate policy -- the Fed’s main tool for delivering maximum non- inflationary growth and stable prices -- has gone underground, even as a series of books on the crisis point to ultra-low interest rates as the main culprit for the housing bubble.

Public comments by policy makers pretty much ignore monetary policy. Instead, officials reiterate the need for enhanced regulation and focus on the Fed’s exit strategy, reassuring us that the central bank has the tools to unwind the $2.1 trillion balance sheet and sop up the $823 billion of excess reserves banks are holding without fanning inflation.

Challenging the Paradigm

After repeated bubbles and busts over the last two decades, starting and ending with real estate, policy makers have to be concerned about the effect of an overnight rate that sits close to zero right now.

“Very few are raising the question, does monetary policy have a role to play?” says William White, chairman of the Economic Development and Review Committee at the Organization for Economic Cooperation and Development in Paris. “Relying solely on regulatory mechanisms to moderate a ‘boom’ might also prove insufficient.”

For over a decade from his perch at the head of the Monetary and Economic Department at the Bank for International Settlements in Basel, Switzerland, from 1995 to 2008, White advocated leaning against the credit cycle. His views ran counter to what he calls the “dominant analytical paradigm” used for the conduct of monetary policy at the Fed and, to a lesser degree, at other central banks.

Targeting Straw Man

Under the leadership of Alan Greenspan, the Fed’s attitude (the equivalent of Greenspan’s attitude) toward asset bubbles went something like this:

Central bankers can’t identify asset bubbles a priori;

Central bankers can’t pop bubbles without inflicting damage on the economy;

Therefore, central bankers should ignore asset bubbles and clean up the mess when they burst.

Greenspan and his underlings framed the discussion in terms of “targeting” asset prices, which White says is a straw man.

“To favor leaning against the credit cycle is not at all the same thing as advocating ‘targeting’ asset prices,” White writes in a new paper, “Should Monetary Policy ‘Lean or Clean,’” originally presented at the Bank of England.

Rising asset prices are a symptom, an imbalance, arising from easy credit conditions, according to White.

Composite Diagnosis

No one is suggesting policy makers in Washington hold a finger to the wind to determine whether higher oil prices constitute a bubble or are a reflection of the fundamentals. All White is saying is that central bankers should recognize that asset prices don’t levitate on their own. Rather, they’re the result of easy money and credit. Instead of treating the symptom, central bankers should focus on the cause.

And yes, there are red flags that scream “bubble” to anyone who’s listening. A combination of rapid growth in money and credit, increases in a broad spectrum of asset prices and deviations in spending patterns argues for leaning against the wind with policy that would be tighter than otherwise, White says. “Combining the refusal to lean with an eagerness to clean implies that the Fed’s policy has been highly asymmetrical over the credit cycle.”

That asymmetry has translated into a successively lower funds rate to treat the fallout from each successive asset bubble until it reached absolute zero last December.

I’m not sure what that says about the economy or what it means for Fed policy in the future. All I know is, this is one of those trends economists refer to as “unsustainable.”

(Caroline Baum, author of “Just What I Said,” is a Bloomberg News columnist. The opinions expressed are her own.)

To contact the writer of this column: Caroline Baum in New York at cabaum@bloomberg.net.

Last Updated: September 22, 2009 21:00 EDT