Bubble, bubble toil and trouble

By Christopher Swann
July 29, 2009

NEW YORK, July 29 (Reuters) – The Federal Reserve seems to be volunteering to be top bubble burster. In a recent speech, Bill Dudley, the president of the Federal Reserve Bank of New York, overturned more than a decade of Fed orthodoxy by claiming it was the central bank’s duty to defuse asset price bombs before they detonate.

As the United States struggles with the fallout from the bursting of the housing and credit bubbles, the Fed may win applause for being proactive. By the time the next one starts to inflate, however, Fed officials may regret they raised their hand. Doing the job properly will certainly make them unpopular and there is no guarantee that it will even work.

But this is no reason not to try. Reducing violent swings in asset prices would be a hugely valuable service. As the latest crisis demonstrated, asset manias can devastate the banking system, stop the economy dead in its tracks and decimate the wealth of Americans.

The first problem the Fed would face is in identifying bubbles. A bubble is a market where assets become overvalued relative to the future returns they offer. Sadly, without a crystal ball, pinning down future returns is difficult. This was Alan Greenspan’s chief objection to targeting asset prices, although his famous “irrational exuberance” speech suggests he knew a market mania when he saw one. Having identified a market delusion, the Fed would then face a political hurdle. Asset price surges create wealth. They are popular. Politicians see them as a vindication of their policies.

A Fed chairman who dared to tighten policy to slow house price appreciation would need nerves of steel. “Even a slight change in regulation on housing and you get upwards of 30,000 angry letters,” says Vincent Reinhart, a former Fed official.

Finally, the Fed would face practical problems. Monetary policy is a crude tool. Try to crack a nut with a large hammer and you may end up breaking the table. Alternatively, you may damage the table and fail to hit the nut altogether — undermining the economy without puncturing the bubble.

Despite the difficulties, Dudley is right to be positive. While one measure alone might not have slowed house price growth, a host of small steps might have helped contain the problem.

“If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep skin in the game, I think the housing bubble might not have been so big,” Dudley argued in his speech last month.

He is right to imagine creating tools to fulfill this task. Adjusting margin requirements for stock purchases, for example, might not stop determined buyers but it would have a powerful signaling effect. Forcing mortgage originators to issue clearer warnings to borrowers about interest rate risks might also have been helpful.

Economists are also working on more reliable bubble-spotting tools.

Leigh Caldwell, a behavioral economist, points to experiments to monitor irrational exuberance. The extent to which consumers have become unmoored from reality can be determined through tests of small target groups, he argues.

“I propose that regulators develop a small set of measures of irrationality that can be calculated and published at least monthly,” he said in a paper published on the Vox EU web site. This approach has yet to be tried on a broad canvas but could provide a valuable addition to the central bankers’ tool-kit.

It is far from certain that the Fed will emerge from the overhaul of regulation as the chief systemic regulator. But it could still play a vital surveillance role.

Since the Fed exerts great sway over the banks, it would be central to any effort to dampen over-enthusiastic markets. The Fed also has an army of economists and sifts vast amounts of data on consumer and banking finances.

It is a great step forward that the central bank has acknowledged that it may be possible to identify and prick bubbles. The Fed may now have several years to hone its irrationality sensors before the next market mania puts it to the test.

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