Is the Fed Likely to Act If There Is Another Stock Market Bubble?

April 5, 2010

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Is the Fed Likely to Act If There Is Another Stock Market Bubble?

That title is a bit of a rhetorical question, because I think the stock market bubble has already arrived, and the Fed is pumping the bellows. But let us not allow that detail to impede the progress of our discussion. Let’s assume that only the next leg up in this monetary experiment will be breaching the limits of the bubblesphere.

Mark Thoma has ‘reblogged’ a review of Dean Baker’s book False Profits from Brad DeLong Site at his own, The Economist’s View.

Brad, the blogging professor from Berkley, takes issue with Dean Baker’s book, concluding:

"But let me start by saying how I disagree with the book. I think that its story of the linkages between our current crisis and Federal Reserve policy is significantly overstated. Its argument about how excessively-low interest rates caused the housing bubble is exaggerated. I think that its belief that the Federal Reserve could have taken much more action to curb the housing bubble while is underway is also exaggerated…"

Well, at least he is consistent. In censuring my criticisms of Mr. Greenspan’s monetary policy back in 2004 which I made as comments on his blog, Mr. DeLong said that Greenspan "never made a policy decision with which I disagreed." Although I was incredulous, I took him at his word.

Not even Greenspan apparently is willing to say that anymore. Although he is very willing to forget the activist role he took in promoting banking deregulation and the expansion of leverage and derivatives, and the rough treatment measured out to those who dared to disagree with the powerful bureaucrats at the Treasury and the Fed. Reich Levels Broadside at Greenspan, Rubin, Summers and Phony Financial Reform

But the comments to this blog were quite interesting and led me to another review of Dean Baker’s book by ‘Daniel’ over a Crooked Timber.

I found the first comment after Daniel’s review to be particularly interesting.

kevincure: 04.03.10 at 6:21 PM

"I was at the Fed in 2006. Everybody at the Fed was aware that there was a housing bubble. The fact that rents and house prices had diverged was known to all of the policymakers I interacted with.

The question was not, is there a bubble, but rather, can monetary policy improve welfare by popping that bubble. The general opinion was no. First, monetary policy is an economy-wide hammer, and housing in only one sector. Second, housing bubbles were prevalent worldwide, and in fact were stronger in many other countries than the US, so it was difficult to imagine that non-extreme changes in policy would affect the bubble. Third, “use policy to clean up the mess after the bubble pops” was, I think, absolutely the right policy in 1987 and 2000, so a model of housing bubbles would have needed to explain what was different this time – even now, lost wealth from housing price declines are not, as far as I know, greater than the wealth decline of the dot-com bubble. That is, the housing bubble in and of itself required no different monetary policy, even with perfect hindsight.

The difference was in the financial markets, where for a variety of reasons (high leverage ratios, principal-agent problems, etc.), the decline in house prices led to what was functionally a bank run. The Fed was not the primary regulator of investment banks in the US, and is one of at least five regulators of local banks (OCC, FDIC, OTS, and state regulators among the others). This isn’t to excuse the Fed – they should have had an office looking at systemic risk! – but merely to point out that very few people saw systemic risk as a major problem in 2006, primarily because of a belief that shareholders and managers were capable of taking better care of their own firms and jobs. This was wrong, but the common criticisms of Baker and Shiller and others about Fed policy and housing bubbles completely abstract away from the real cause of the crisis, which was financial.

In any case, a housing bubble – by itself – would have been straightforward to deal with ex post with policy. That was not the problem."

This is not some outlier comment, but an expression of what is a very mainstream thought among a certain class of American economists, especially those who covet positions of power with the US government.

The ‘collateral damage’ caused by the dot.com and housing bubbles, all those ruined lives and families, is really not a problem and can be addressed by monetary policy (inflation) after the bubble runs its course. The problem in this last financial crisis is that the housing collapse caused a bank run, and the banks themselves were injured, instead of profiting, in the bubble collapse. Talk about an unintended consequence. Good God, not the Banks! This is a fast being remedied by the enormous subsidies granted by the Fed, and their man Timmy at the Treasury, to set the Banks back up again at the roulette tables, bringing home those eight figure paydays.

If you think the Fed has learned anything, that they are somehow more prudent, more aware of the greater economy and the impact of their behaviour on the American people after this latest financial crisis, you are sadly mistaken. Their hubris is boundless, and they are able to rationalize almost any damage to the republic as a minor glitch in their experiments.

The answer to our initial question about a new stock market bubble is of course is "no." The Fed will allow a stock market bubble to develop, run its course, collapse, empty even more of the savings and retirement funds of mom and pop, and go happily along on its way as long as the banking sector is maintained in the manner to which it has become accustomed.

And if you think this latest financial crisis has stilled the animal spirits of the merry pranksters on Wall Street you are sadly mistaken. The sociopaths will continue to gamble the nation’s future, and the propeller heads at the Fed will stand idly by waiting to clean up the mess, only afterwards. But the clean up will be carefully targeted to the FIRE sector, and the public will likely have to fend for itself.

And the Congress would like to make the Fed the overarching regulator and the primary owner of an expanded Consumer Protection Agency? Only afer huge amounts of lobbying contributions to assuage their consciences it must be said. To the Fed, the consumer is only grist for the mill from which the bankers obtain their bones to bake their bread.

Asset bubbles are a form of fraud, in that and mispresentation and deception are employed to circumvent genuine price discovery. And like most Ponzi schemes and financial frauds, they are an effective wealth transfer mechanism from the many to the few. And the few will do quite a bit to create them, and then keep them in place.

Some are critical of people like Robert Reich who ‘tell it like it is’ although in softer terms than they might desire to have them speak. Let me tell you, the establishment in the US is closing ranks, and is going to try to ostracize and silence anyone who speaks out against the status quo. And the intimidation of critics and witnesses continues.

The banks must be restrained, and the financial system reformed, and the economy brought back into balance before there can be any sustained recovery.