Bubble, bubble toil and trouble

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.

15 comments

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It would be great step forward to acknowledge that fed creates the bubbles in the first place.

http://www.mises.org

Posted by dvictr | Report as abusive

I agree with the above writer. Since the Fed is cause of the bubbles, why should we trust them to “burst” them. Please do check out http://www.mises.org (economists) or http://lewrockwell.com (lay-people) if you are interested in learning the grisly details.

Posted by jj | Report as abusive

This could get interesting. Remember the dot com bubble? The Economist had a slew of articles identifying the bubble, and even saying that the bubble was about to burst, months – possibly years – before it did. Timing is everything….

Posted by rcollins | Report as abusive

The Fed shouldn’t have trouble finding the next bubble…its right under their nose and the government’s nose. Fannie Mae…Freddie Mac….FHA….Treasury Bonds.
When the U.S. Government paper bubble bursts it will be the dollar that collapses and interest rates will go thru the roof. I have seen movies about the 1920′s and I have heard the phrase a few times “what were they thinking?”. We have put our faith in a central banker knicknamed “Helicopter Ben”. What are we thinking?

This has to be a joke, right? It’s like proposing that a pyromaniac purchase an extinguisher and improve his fire-detection capabilities.

Posted by sb | Report as abusive

CNBC has put together a real nice timeline of events that caused our financial crisis, please copy & paste the following website: http://www.cnbc.com/id/31489482
Also, please note in the slides that another housing bubble CAN be identified if someone is paying attention to the figures.

Posted by Angela Walker | Report as abusive

[...] 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 Transform Your Debt [...]

Why are we allowing a private banking cartel (Fed) such an enormous power to begin with?

Posted by k | Report as abusive

The article: Ben “Systemic Risk” Bernanke proves that Bernanke knowingly maintained a strict monetary policy long after he knew of the sub prime problem as he knew it would cause of the “Depression”.

It shows that he probably engineered it on purpose!

If you want to sleep tonight, Don’t Read It!

“In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that “the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces” (Friedman and Schwartz, 1963, p. 300).
…..

The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October.

In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it.

Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.”

Governor Ben S. Bernanke
Money, Gold, and the Great Depression.
At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University,
Lexington, Virginia.
March 2nd, 2004

You can read also: Preparing for the Crash, The Age of Turbulence Update: 30/07/09., which tries to accomplish Greenspan Mission Impossible:

“That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer.

Much as we might wish otherwise, policy makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances.

Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated – if people see them coming, then the markets arbitrage them away.

The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins.

In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to “get up and dance”, as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share.

Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge. Most were wrong.“

Alan Greenspan
The Age of Turbulence: Adventures in a New World [Economic Order?].

The Age of Turbulence: Plea for a New World Economic Order. explains the nature and causes of economic depressions and proposes a plausible alternative solution.

The article: Ben \”Systemic Risk\” Bernanke proves that Bernanke knowingly maintained a strict monetary policy long after he knew of the sub prime problem as he knew it would cause of the \”Depression\”.

It shows that he probably engineered it on purpose!

If you want to sleep tonight, Don\’t Read It!

\”In contradiction to the prevalent view of the time, that money and monetary policy played at most a purely passive role in the Depression, Friedman and Schwartz argued that \”the [economic] contraction is in fact a tragic testimonial to the importance of monetary forces\” (Friedman and Schwartz, 1963, p. 300).
…..

The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October.

In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it.

Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.\”

Governor Ben S. Bernanke
Money, Gold, and the Great Depression.
At the H. Parker Willis Lecture in Economic Policy, Washington and Lee University,
Lexington, Virginia.
March 2nd, 2004

You can read also: Preparing for the Crash, The Age of Turbulence Update: 30/07/09., which tries to accomplish Greenspan Mission Impossible:

\”That is mission impossible. Indeed, the international financial community has made numerous efforts in recent years to establish such oversight, but none prevented or ameliorated the crisis that began last summer.

Much as we might wish otherwise, policy makers cannot reliably anticipate financial or economic shocks or the consequences of economic imbalances.

Financial crises are characterised by discontinuous breaks in market pricing the timing of which by definition must be unanticipated – if people see them coming, then the markets arbitrage them away.

The clear evidence of underpricing of risk did not prod private sector risk management to tighten the reins.

In retrospect, it appears that the most market-savvy managers, although conscious that they were taking extraordinary risks, succumbed to the concern that unless they continued to \”get up and dance\”, as ex-Citigroup CEO Chuck Prince memorably put it, they would irretrievably lose market share.

Instead, they gambled that they could keep adding to their risky positions and still sell them out before the deluge. Most were wrong.\”

Alan Greenspan
The Age of Turbulence: Adventures in a New World [Economic Order?].

The Age of Turbulence: Plea for a New World Economic Order. explains the nature and causes of economic depressions and proposes a plausible alternative solution.

well, reading the comments, it seems obvious to me that everyone knows the federal reserve is a crime syndicate.

funny how the newswires never report on it…only comments that will surely be deleted in time.

Posted by spliffy | Report as abusive

The problem isn’t just the Fed, or the banks, the problem is that we have invented a system where the only thing that matters is how much money you’re making right this second, and where the penalty for not doing so far exceeds the penalty for cataclysmic failure.

The CEOs of Citigroup, BoA, JP Morgan, etc. didn’t get charged with fraud or perjury, they didn’t have all their assets and property seized and get tossed on the street, they didn’t even lose their supposedly merit based bonuses for the year that their banks came so close to going under and demolishing the current US economy that the only way they could be saved was giving them TRILLIONS of dollars that we don’t even have…

Had any of them decided in 2006 that the whole thing was a house of cards that put in extreme danger not only their firm, but the entire US economy and voluntarily stopped doing all of those monumentally stupid things, they would have been charged with insider trading, sued by the shareholders for shirking their fiduciary responsibility (the only moral imperative a publicly-traded corporation actually has), and had any salary or benefits owed to them revoked for breach of contract.

Blame the Fed if you really want to, but the fact of the matter is that our system might as well be intended to foster irresponsibility, economic schizophenia, greed beyond any sense of reason or purpose and inexorable self-destruction. The fact that we don’t merely allow such a thing, but actually encourage and take pride in it, is a frightening testament to how irresponsible, schizophrenic, greedy and self-destructive we all are.

Posted by Mike Miseph | Report as abusive

Speculation is increasing prices and would increase further higher when economy rebound,
unless they are controlled, now !

Most Important Tool to control this is:

Making it 50%-100% margin call requirement for all Speculative Position ( Not Delivery based Position) on this Commodity Exchanges.

Most of Investment are in done with with Very Low Investment (margin money) requirement which are about 5-10% normaly.

The increase in Margin Call requirement (Security Money = 100% of Value) i.e Amount to be Invested to take Speculative Position on Exchange would bring the market to it REAL VALUE !

** This would increase Cost of Investment.

** This would bring the Actual Business (mfg/traders)
to Par with this Speculators.

** Did any one make Calculation in difference about Actual Mfg/Trading = Speculative Investment

Actual Mfg: need, 100% Money Investment, Warehouse, Staff, Transportation, Banking, Sales and Other Taxes.

Speculators: need, 5-10% of money Investment, A Broker and Computor system !

Which business you will do sir ??

M Chandan
India

Posted by M Chandan | Report as abusive

VERY interesting piece on the ECRI’s site about their Leading Home Price Index.

Charts here: http://www.businesscycle.com/

Part of post… (from May)

END OF HOME PRICE DOWNTURN IN SIGHT

“With U.S. home values far below their boom-time highs, most observers are resigned to an indefinite downdraft in home prices. It is this uncertainty about the ultimate bottom in home prices that has converted so many mortgage-related derivatives into toxic assets. Yet, at long last, the end of the home price downturn is in sight.

One key reason for the turnaround in the outlook is housing affordability, which is hovering around all-time highs. The current combination of drastically reduced home prices and very low mortgage rates has hardly ever been seen in living memory…

Most importantly, the U.S. Leading Home Price Index (USLHPI), designed to predict cyclical turns in real home prices, has now been rising for five months… But a three P’s analysis (see chart below) of the level of the USLHPI reveals an even more promising picture… the recent upturn in the USLHPI is almost as pronounced as the median in comparable past cycles… it is almost as pervasive; and … it is just as persistent. The implication is clear: this is a genuine cyclical upturn in the level of the USLHPI. Such an upturn in the USLHPI amounts to a forecast of a cyclical upturn in the level of home prices this year…”

Posted by Owen B | Report as abusive

Is the Fed’s job to try and predict the market so it can smooth out the rough spots? If so, then it would seem that from the point in time they begin to do this, they start distorting the market, and eventually they loose the market as happened in Russia. They come closer and closer to managing the market and all that means is that they tell people what they need from the top down.

If it were not for the Fed, my family of four could take a 5 day trip to Florida Disney World for $30 (look up the price of a $20 gold piece from 1900). The Fed has managed to “help” prices inflate (by devaluing the dollar) every year by a small amount. But what we never have realized are gains in productivity. Every year we are more and more productive, but we have never realized these gains. What this means is that prices should be falling as opposed to rising. This would make it a good thing to save. However the Fed is a large secret bank that is in business to help other banks, and a bank wants you to be in debt.

Of course we would not have grown to the point we have without some debt, but rates should be market driven as opposed to driven by the Federal Reserve. This would have provided a natural rate of growth and more steady prices.

Posted by dave | Report as abusive

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

[...] could be conducted with broader aims: “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 [...]

Please help me about the trend gbp/usd for tonight till tomorrow!(including the range movement)

[...] could be conducted with broader aims: “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 [...]