Can the federal reserve identify and prevent financial bubbles?

Should the federal reserve try to prevent asset bubbles or merely clean up in the aftermath?

house_in_bubbleFinancial manias are costly to society because they divert scarce resources away from productive ends toward wasteful enterprises that consume resources without creating any real value. If we could identify asset bubbles and eliminate them before they started, our economy would more efficiently allocate the resources available.

Do you remember the dotcom bubble? Thousands of new web companies obtained financing to launch dubious ventures that squandered investor money creating no value. Often the only residual value of these businesses was the salvaged phone systems or office cubicles; the products were worthless. Couldn’t that money have been invested in something more productive?

federal-reserve-econimistsThere is little argument over the idea of preventing financial bubbles, but there is little agreement over how to accomplish this in the real world, mostly because nobody can accurately identify financial bubbles while they form.

If asset prices rise far faster than historic norms for an extended period of time, economists traditionally infer some fundamental reason that isn’t there; further, when prices crash absent any recognized shock, these same economists claim that investors should have known better than to extrapolate price trends rather than relying on fundamentals. The cognitive dissonance is shocking.

When I wrote The Great Housing Bubble, I reviewed the research from federal reserve economists, and even when they had the evidence right in front of them, they failed to see the obvious.

For example, the chart below was pulled from a federal reserve study from late 2006. Upon reviewing this data, what would an economist conclude?

Housing -- Boom or Bubble-9

The rise in house prices over the past 10 years can be explained mainly by fundamental factors, namely, rising income and falling interest rates.

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Even a cursory examination of the impact of interest rates would show that declining mortgage rates only added about 10% to the fundamental value of houses, but prices rose more than 50%. The glib answer provided in the summary is typical of what economists said back at the peak of the housing bubble.federal_reserve_economist

Given that economists failed to see one of the largest, most obvious, and most destructive financial bubbles in modern history, what reason do we have to believe they can spot any financial bubble?

I have my doubts federal reserve economists will agree on the right course of action even if they can agree on a bubble. Some economists will vehemently disagree with their colleagues. Many economists get caught up in their own confirmation biases and interpret incoming data through the filter of what they want to see happen. Reaching a consensus will be difficult. Just look at the problems the Canadians, Chinese, and Australians have admitting to their housing bubbles.

With the realities of identifying and then agreeing on a course of action being so problematic, for as much as I like the idea of stamping out housing bubbles before they blow up, unless we get much better at identifying them and crafting policies to deal with them, we must focus on solutions to cleaning up the mess after the fact.

The Threat of Bubbles, Not Inflation, Should Guide Fed Policy

By John Cassidy, March 6, 2015doing_nothing

… the constant focus on the link between inflation and unemployment, which is evident in the minutes of the Federal Reserve’s Federal Open Market Committee and in the media discussion of what the Fed should do next, does present a real danger. It reflects an outdated economic paradigm that, twice in the past twenty years, has misled policy-makers and produced bad policy decisions.

During the late nineteen-nineties, and again in the mid-aughts, the Fed set interest rates based on the supposed threat of inflation. When that threat failed to materialize, it kept rates at low levels for long periods. Cheap credit, in turn, encouraged the development of speculative bubbles and other financial imbalances. And when the bubbles eventually burst, the economy went into recession. But rather than changing its policy framework to prioritize avoiding yet another speculative bust, top Fed policy makers once again committed themselves to focusing on inflation, publishing a target rate of two per cent. Bubble-prevention was delegated to the Fed’s regulatory apparatus.

What is often lost in the discussion about the federal reserve combating financial bubbles is the role the federal reserve plays in inflating bubbles.

Financial bubbles are nearly always spawned by cheap debt that becomes mis-allocated, often because it has nowhere else to go. Those bubbles are direct byproducts of federal reserve activities. But what should we do about it?

For example, many people believe government bonds are a bubble in search of a pin, but as foreign investment continues to pour in to these overpriced assets, should we stop them? Should we put a warning on investments? Actually, we already do, so that won’t change much.Janet-Yellen-Bubble

When you think about current conditions in the bond market, the idea of identifying and doing something meaningful about asset bubbles becomes exposed as folly.

At the moment, thankfully, the threat of another bubble appears to be contained, despite ultra-low interest rates. Still, it can’t be ignored. Rather than obsessing about inflation, Fed chair Janet Yellen and her colleagues should be seeking to provide as much support as they can to the economy, consistent with preventing bubbles from forming in asset markets such as stocks, bonds, and, especially, real estate. That is where the threat lies, not in rising inflation.

So how is the federal reserve supposed to support asset prices with low interest rates and avoid blowing bubbles? The federal reserve even published a long study on methods for predicting bubbles back in 2004, but obviously, they didn’t come up with a secret code to discover them because they missed the obvious one inflating at the time of the paper’s publication.

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Things used to be different. In the nineteen-seventies and nineteen-eighties, there was very real danger of a wage-price spiral (in which rising wages and prices become self-reinforcing, pushing inflation upward). In the fall of 1974, the rate of inflation topped twelve per cent; in 1980, it reached almost fifteen per cent. But in today’s globalized and technology-driven economy, workers have little bargaining power, and the prices of many products, such as electronics, have a tendency to fall rather than rise. The last time the inflation rate rose above six per cent was 1990—twenty-six years ago. …

(See: Why were predictions of devaluation and hyperinflation wrong?)real-time_mistake

In short, the real policy dilemma isn’t the trade-off between inflation and unemployment. It’s the tradeoff between cheap money and financial instability. How long can the Fed keep interest at ultra-low levels without sparking another bubble and all that goes with it?Stock prices are already high—very high. So are corporate profits, which explains a good deal of the recent rise in the Dow and the S&P 500.

Note the confusion as to whether or not the rise is a bubble or based on fundamentals. This same pattern emerges in every discussion where prices have risen to quickly for too long.

But the market’s price-to-earnings ratio, a standard valuation metric, has also been going up, indicating possible overvaluation. And Silicon Valley and other technology centers are doing so well that Mark Cuban, the owner of the Dallas Mavericks, who became a billionaire during the last tech bubble, wrote a blog post earlier this week entitled “Why This Tech Bubble Is Worse Than the Tech Bubble of 2000.”

David Stockman, a noted bear, also calls the stock market a bubble.Janet_Yellen_housing_bubble

Real-estate prices are also rising, particularly in places that played a big role in the last bubble, such as Miami and San Francisco. At the national level, however, prices rose by just 4.5 per cent last year, according to the S&P/Case-Shiller 20-City Composite index. That doesn’t seem too alarming. Neither does the state of the mortgage market. To the chagrin of some potential buyers, banks seem still to be acting relatively cautiously when doling out credit.

(See: New mortgage regulations change how real estate markets work)

Based on this brief survey, my tentative conclusion is that the Fed still has some room to maneuver. Some bubble indicators are starting to flash amber, but there is little sign yet of the kinds of alarming financial imbalances that emerged in the late nineties and mid-aughts. In any case, this is where the Fed ought to be focusing its attention. The “inflation threat” is a red herring.

I like the idea of focusing on eliminating bubbles. Please tell everyone how to do it, then the advice may have more meaning.

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