Fed shouldn’t play bubble buster | VailDaily.com
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Fed shouldn’t play bubble buster

NEW YORK – Much has been made of the divergent views on public inflation targeting held by Federal Reserve Chairman Alan Greenspan and his appointed successor, Ben S. Bernanke.Much less attention has been paid to another important policy area where the two men are in absolute agreement: the futility and even danger of the central bank trying to deflate asset “bubbles,” such as the technology stock insanity of the late 1990s.The failure to prick the late 1990s stock bubble as it inflated is one of the criticisms that has been regularly hurled against Greenspan’s generally vaunted 18-year tenure atop the Fed. In fact, some argue post-bubble monetary policy of significantly lowering short-term interest rates, and thereby reducing mortgage rates, helped lead from one bubble to the next. That’s if you think there’s currently a “bubble” in U.S. housing prices.Greenspan has occasionally seemed defensive about this bubble-busting business, but he has always been on target about the impossibility of asking the Fed to definitively spot bubbles as they emerge and then use monetary policy tools to contain them without scuttling the whole U.S. economy.In late August 2002, Greenspan said: “The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion.”Bernanke made a clear-cut, winning case against casting the Fed as a bubble-buster in an October 2002 speech. If anything, the man who will be the next Fed chairman, pending Senate approval, feels even more strongly about the subject than Greenspan.Bernanke even wheeled out the most glaring example of attempted bubble-busting gone wrong: the monetary policy mistakes that helped lead to the Great Depression.In light of Bernanke’s pending elevation to Fed chairman, a position still without equal in its economic power, it’s worth revisiting his views on the subject of bubbles.After all, there might be one now in housing prices, and surely there will be others during Bernanke’s tenure.In the October 2002 speech, Bernanke summed up his views this way: “First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.”Better that the Fed should stand ready, as it has in the past, to mitigate the negative effects of the inevitable bursting of a bubble. The central bank should make sure financial institutions and markets are “well prepared for the contingency of a large shock to asset prices,” Bernanke said at the time. Most important, the Fed should provide liquidity until the immediate crisis has passed, as it did after the stock crash of 1987, Bernanke added.Bernanke’s treatise on bubbles, while soundly argued, does hint at the concerns expressed by those who think he is too much of the academic world and too little of the messy, real world of business and markets. Burst bubbles and their consequences, as vast sums of wealth simply disappear, rank high in real-world messiness.While it’s true Bernanke’s arguments are theoretically neat on this topic, it’s important to remember the key aspects of the view are fully shared by Greenspan and others at the Fed. And Greenspan certainly has been battle tested.Urging the Fed to identify and then somehow harmlessly deflate asset bubbles is a strange desire of people who claim to believe in free markets. Bubbles aren’t really that easy to identify when they are growing. After the fact, it’s easy.To declare a bubble exists, the Fed “must not only be able to accurately estimate the unobservable fundamentals underlying equity valuations, it must have confidence that it can do so better than the financial professionals whose collective information is reflected in asset-market prices,” Bernanke said.There are smaller, negative side effects to this policy. Bernanke said it “would only increase the unhealthy tendency of investors to pay more attention to rumors about policy makers’ attitudes than to the economic fundamentals…”You could see a vicious circle forming. Investors who expect the Fed to identify and safely deflate bubbles will take on even more risk, creating more bubbles, since they will believe they are protected from the consequences of their actions.”Because risk-taking is essential for economic dynamism, we do not want an economy in which investors and business people are not free to take bets that might turn out badly,” Bernanke said.Then there’s the issue of how you would burst a bubble.Greenspan and Bernanke agree that raising interest rates somewhat more than economic conditions otherwise call for likely wouldn’t do the trick. You need drastic rate increases. You might stop the bubble, but the cost would be too high, needlessly killing broad economic growth.Which brings us to Bernanke’s lesson from the Great Depression. He said that in 1928, with the inflation rate slightly negative and the economy barely emerging from recession, the Fed began to raise rates to fight the stock market bubble. The discount rate went from 3.5 percent in January 1928 to 6 percent in August 1929.”The correct interpretation of the 1920s, then, is not the popular one – that the stock market got overvalued, crashed, and caused a Great Depression,” Bernanke said. “The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy … was to slow the economy – both domestically, and through the workings of the gold standard, abroad.”—EDITOR’S NOTE: Neal Lipschutz is vice president and managing editor of Dow Jones Newswires.Vail, Colorado


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