That’s a question recently taken up by
the Wall Street Journal. Here are my thoughts.
Before we can discuss this issue, we’d need to agree on what we mean by a “bubble”. Here’s one definition that a lot of people may have in mind: a bubble describes a condition where the price of a particular asset is higher than it should be based on fundamentals and will eventually come crashing back down.
If that’s what you believe, then there’s a potential profit opportunity from selling the asset short whenever you’re sure there’s a bubble. And if that’s the case, my question for you would be, why don’t you do put your money where your mouth is instead of telling the Fed to do it for you? Your answer might be that it could take years for the bubble to pop, and you’re not willing to absorb the risk in the interim. Or maybe you don’t have the capital to cover the necessary margin requirements while you’re shorting the bubble on the way up.
Even so, posing the statement in this way should bring a dash of humility to those currently claiming to see a plethora of bubbles that the Fed supposedly needs to fight. What exactly persuades them that they are right and all the other players in the market are wrong? How much of their personal wealth are they staking on the strength of their convictions? And even if you’re absolutely sure you know how to identify bubbles, raising interest rates as a response is, as Tim Duy observes,
“a rather blunt weapon that kills indiscriminately”.
Another concept of a bubble that some people may instead have in mind is one involving the fundamentals themselves, in the form of temporarily and unsustainably low interest rates that are causing the temporarily and unsustainably high asset price. Professor James MacGee of the University of Western Ontario had an interesting discussion (hat tips: Marginal Revolution and reader Robert Bell) of why house prices in the U.S. overshot their long-run values by so much more than those in Canada.
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MacGee notes that the Bank of Canada, like the U.S. Federal Reserve, had lowered interest rates quickly in 2001-2002, though it did not follow the U.S. quite as far down in 2003-2004.
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The Canadian path for interest rates is closer to the one that Stanford Professor John Taylor has suggested that the U.S. should have followed.
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MacGee argues, and I agree, that weak underwriting standards in the U.S. were a bigger problem than the low interest rates. And we share Tim Duy’s assessment that better regulation would have been more important than getting the interest rate right. Nevertheless, I am also sympathetic to Taylor’s suggestion that the exceptionally low U.S. interest rates in 2003-2004 were pouring fuel on the fire.
It is hardly the role of the Fed to be deciding that it knows better than the market what the price of every asset should be. Nevertheless, I think it is necessary for the Fed at least to be forming an opinion about what’s driving asset prices as one input into the Fed’s decision making. Booming U.S. real estate prices were accurately signaling that there was a problem with both the interest rate target and financial supervision, and it’s desperately important to ensure that this same mistake is never repeated.
Of course, it’s easy enough to say what should have been done in 2004. but the real challenge is figuring out what to do in 2010. Are commodity prices experiencing a bubble right now, and if so, is it something the Fed needs to stop? To me, the evidence suggests that U.S. interest rates are an important factor in recent movements in relative commodity prices. I also believe that further big increases in commodity prices could be destabilizing for the real economy. Nevertheless, other economic objectives take precedence at the moment, and it is too early to start raising rates yet. But it is not too early to remember that there are limits to how much you can help the U.S. economy by keeping interest rates low.
I suggest watching commodity prices in the months ahead as one practical guide for acting on that wisdom.
“It is hardly the role of the Fed to be deciding that it knows better than the market what the price of every asset should be.”
Do you also believe it is hardly the role of the Fed to be deciding what short-term interest rates should be?
Small savers in this nation have been forced for many years now to lend their money to banks at interest rates that are near zero or even negative after inflation. Would this have been so in a genuine freee market, where they did not face competition from the Fed’s printing press?
Now, not only small savers, but nearly everyone, is forced to lend their savings at negative real interest rates. The Fed is intervening not only in the short-term market, but also, massively, in the MBS market.
>>”If that’s what you believe, then there’s a potential profit opportunity from selling the asset short whenever you’re sure there’s a bubble. And if that’s the case, my question for you would be, why don’t you do put your money where your mouth is instead of telling the Fed to do it for you?”
Well, do you think the Fed and govt would let the market crash? You speak as the if you are totally oblivious to what the govt has been doing since the crisis.
The govt and Fed makes bubbles a one-way bet.
I don’t think there is any dispute among reasonable people that interest rates are too blunt to be used to control speculation. Regulation is the correct approach.
In my opinion, the interest rate point is most often set up as a strawman to be knocked down. It goes like this – interest rates were set correctly/is too blunt an instrument to control bubbles; ergo the Fed is absolved of any responsibility for this crisis.
The Fed is fully responsible for this crisis because of its utter and complete failure to use its regulatory powers.
“low U.S. interest rates in 2003-2004 were pouring fuel on the fire.”
What about the role that long term interest rates played in the bubble? Even as the Federal Reserve was raising short-term interest rates, there was no corresponding rise in long term interest rates, which affect fixed rate mortgage financing (the most popular way of buying houses.)
The key to fighting rising consumer prices is short-term rates. The key to fighting asset prices is long-term rates, which the Fed has limited control over.
Regarding the question of why more people don’t sell obviously bubble-state markets short, the answer is simple: With the Fed willing to force real interest rates to zero at any sign of financial system distress, and unwilling to raise them despite obviously insane market conditions such as those of the dot-com bubble, selling short presents far too much risk for the potential reward. Though the NASDAQ was in an obvious bubble at 2500 in 1998, anyone lacking the capital to cope with its doubling to its peak in 2000 would have seen their position margin-called out existence. Not only would they not have made a penny on the ultimate plunge, they’d have been wiped out. And if they had had the capital to meet the margin calls, then the ultimate return on the capital locked up by the short position would not have been very high.
And although in retrospect we can see that it would have been sufficient to back such a short position with enough capital to deal with a rise to 5000, how could one have know that would be enough? With the Fed completely nullifying all market mechanisms and setting short-term rates wherever it wants, there is no limit to how far bubble prices can depart from sane levels. The NASDAQ could easily have gone to 10,000 before collapsing.
I’ve now seen Citi management and stockholders bailed out three times in the last 30 years by the Fed lending to them at short-term rates a fraction of what any free market would have charged.
Hear! Hear! jm.
How about a little democracy in capitalism. Might do something for the “wealth gap” too.
As far as bubbles go, size matters, and I have no desire to try and determine if me, and by definition all other investors and the Fed decide there is a bubble and we all pop it at the same time. I’d like to remain retired and have no desire to re-enter the job market if I get the roll of the dice wrong on that one.
There are ways to get a feel if asset values are pricey however, and the Fed does not consider this in policy making.
And personally, I don’t really agree that low interest rates “fix” the economy. People worry about cash for whatever pulling demand forward, but what would low rates do, assuming the banks were cooperating and lending and cutting credit card rates. Which they are not.
So a steep yield curve is welfare for banks. And it causes savers and investors to take more risk when chasing a tiny return, and this makes assets at least richly valued, and maybe go into bubble territory. But we may be learning some new found restraint lately.
So we are growing tomorrow’s toxic assets whenever interest rates go back to normal, whether it’s by design, accident, or actions of bond or currency vigilantes.
I think someone needs to take a fresh look at cost-benefit of this knee jerk policy.
Rajesh, the Fed has more control over long rates than you think. They didn’t sell a lot of long dated maturities during the “conundrum” years. If they wanted long rates up, they could of easily offered more long stuff and less short stuff. But they steadily shortened up the overall duration of treasuries instead.
Also, I think there is a relationship between easy money, stimulating the economy, and regulatory and underwriting lapse. I have the feeling that all parties were on the same side this decade.
Raj
Whoops, I misspoke. I meant to say the USG has more control of long rates. I am aware that the treasury is the one that issues bonds. They could sell more long notes if they wanted rates up back during the boom. Or lately, the Fed could refrain from buying them.
As a reader, thank you for yet another great post. The definition of a bubble forming when prices exceed fundamentals is reasonable, but it may presume that the fundamentals are always correct. Are there instances when asset prices remain high and the fundamentals adjust upward?
A bubble in commodity prices actually dampens economic activity, so raising rates along with commodity prices during a recession would be disastrous. Commodity pricing is driven by global demand. The Fed needs to “take away the punch bowl” when the party starts to rock, not when the utensils become scarce.
There’s a related issue. It’s impossible to look only at one variable (interest rate, m2, etc.) and know if policy is too stimulative, because there are changes in specific markets and financial structure that render old relationships suspect.
In the early 2000s, Greenspan believed that low interest rates were not inflationary because the CPI was not accelerating. Michael Mussa had warned that excessive stimulus may have manifested itself in asset markets rather than the prices of current consumer goods. (DeLong on Mussa: http://delong.typepad.com/sdj/2008/10/greenspanism-an.html).
I’d be nervous about the Fed trying to prick asset bubbles, but I think they should combine asset prices with consumer prices in evaluating whether policy is too stimulative.
So now we have high global demand, global recessions? What next. Let’s raise our business and consumer input costs and party all the way to the bank.
But of course banks can deleverage, fix up balance sheets and pay big bonuses all at the same time. Nice biz, never worked worked that way anywhere I ever worked, especially during a recession. No one got a bonus and we even got pay cuts in 1982. And we didn’t even cause the recession!
While the housing bubble was plainly visible, the issue, from my perspective, was not the price of housing per se, but rather the debt incurred on the back of inflated values. That turned out to be enormous, up to 40% of GDP. It is this indebtedness, not the housing price crash, which is crippling the economy. The Fed, to all appearances, stood idly by while America got in over its head. In retrospect it is clear the Fed should have intervened.
There is not much precedent though (I think) for the Fed to raise interest rates in absence of meaningful price inflation. Therefore, the Fed arguably acted correctly in meetings its price stability and full employment mandate. To intervene, the Fed would have had to argue that it was raising rates in effect to ‘sterilize’ the excess liquidity pouring into the financial system from China. I am not sure there’s any precedent for this.
And even if the Fed had wanted to deflate the housing bubble, would the political climate have supported it? Would the Bush administration have stepped up and, in effect, taken the heat for the Fed? I don’t think so.
A bubble should matter if it risks leading to real economic imbalances in the form of factors of production rushing to specific sectors. The recession that may result will put downward pressure on the price level.
If the USA is keen to reduce the foreign commodity bill, there are better, more direct ways such as excise taxes.
The Canadian comparison adds a bit more evidence of the Fed’s contribution to the housing bubble. I would further suggest that the laxness among US financial institution was contributed to by the extreme looseness of money & by the perverse regulation of the rating agencies [a gov’t-endorsed oligopoly.]
Also worth noting is the contributions of the Asian central banks in lowering long-term interest rates.
But to view this issue more broadly, the Fed has been the sine qua non of the Dotcom bubble, the housing bubble, & the present distortions in asset values. Without its loose supply of fresh credit to borrow that no one has ever saved, none of these distortions would have occured.
For instance, as the demand for high tech investment increased in the 90s, if we had had free market provision of money & banking, this increase in investment demand would have increased interest rates to naturally choke off over-investment. Since the Fed did not perceive CPI inflation on the horizon, it supplied all the credit the Dotcom bubble wanted.
The Fed is about suppressing the free market in money/banking. Fiat money cannot exist otherwise. You then want to complain that it manipulates interest rates stupidly? What did you expect?
I largely agree with the viewpoint of the parent article, but I wanted to call attention to Andrew Smithers’ work as at least one example of someone who actually makes concrete proposals on bubble measurement. There is a podcast interview (from Dec. 3) here and he has a book called “Wall Street Revalued”. The essence of his proposal is to find two or more fundamental indicators that have good long term regression to an asset price and call a bubble when both are statistically far out of line.
Rajesh,
The reason long-term rates didn’t rise was simply that the Chinese government was recycling the dollars it bought from its exporters to maintain its mercantilist currency peg back into the US by buying longer-maturity GSE and Treasury securities. This screwed us two ways — by fueling the real estate bubble, and by destroying US manufacturing even where it would have had comparative advantage at market-set exchange rates. Because the Fed did not use its bully pulpit to denounce that and support the emplacement of countervailing tariffs, it bears a great responsibility for the outcomes. But raising short-term rates more, and more promptly, would have constrained that evil, too, to some degree.
“But it is not too early to remember that there are limits to how much you can help the U.S. economy by keeping interest rates low.”
Do you mean “But it is not too early to remember that there are limits to how much you can help the U.S. economy by keeping interest rates low along with lax regulation to attempt to create more and more debt on the lower and middle class?
If asset bubbles keep forming from low interest rates, does that mean there are imbalances elsewhere?
Cedric Regula said: “Raj
Whoops, I misspoke. I meant to say the USG has more control of long rates. I am aware that the treasury is the one that issues bonds. They could sell more long notes if they wanted rates up back during the boom. Or lately, the Fed could refrain from buying them.”
What about the fed’s and the government’s policies of cheap labor outsourcing, cheap labor legal immigration, and cheap labor illegal immigration?
Anybody think it was an accident long-term interest rates stayed low with china entering the wto? I don’t.
Few mechanical observations on assets and liabilities (are they leveraged?)
When should money supply be treated as a forceful component of the inflated assets prices? (Is Marshall law a repelled theory?)
http://www.shadowstats.com/article/money-supply
When is excessive credit supply a contribution to the assets prices inflation?
http://research.stlouisfed.org/fred2/series/LOANINV
When are derivatives considered to be additional fuel to the assets prices? (why are banks regulations,such as banks owned funds vs total assets not in compliance?)
http://www.occ.treas.gov/ftp/release/2009-114a.pdf
Why are CPI s, a definition in continuous changes?
http://www.shadowstats.com/alternate_data
Why is a Value at Risk (VAR) tolerated, when a proved mathematical fraud (5 banks share 85 % of the derivatives market)
P12
http://www.occ.treas.gov/ftp/release/2009-114a.pdf
Why is the OOCC derivatives report late in its publication for the third quarter 2009?
How to explain the growing and staggering share of corporate credit over GDP throughout the period 1860- 2007 (from 14.4% to 87.5%)
Please see P 35 P 37
The Evolution of the US Financial Industry from 1860 to 2007: Theory and Evidence.
Thomas Philippon
New York University, NBER, CEPR
November 2008
How should we assess this result? Assets prices in line with incomes and revenues?
http://research.stlouisfed.org/fred2/series/LLRNPT?cid=93
Why, what appeared to be a fraud is no longer treated so ?
Please see reports ( Primary dealers reported fraud on government bonds 2006 2007)
Why should private money be arbitraging when it has good probability of being overwhelmed by the size of the financial markets cartel? (should not it be the duties of institutions,as described through constitutional acts?)
How reliable are stocks markets Pe ?
http://research.stlouisfed.org/fred2/series/USROA?cid=93
Why the attempts to salvage the financial markets during the great depression are said to be of a private initiative (JP Morgan would gather 20 million usd seed money for this purpose) when it has become a universal social contribution and toll?
All above comments may be of universal reach since financial markets have shown an homogeneous behaviour.The end result being a lack of risk diversity and a high concentration of leveraged assets.
What if the fed wants asset bubbles to prevent price deflation?
“If that’s what you believe, then there’s a potential profit opportunity from selling the asset short whenever you’re sure there’s a bubble.”
Pray tell. How does one short single family housing?
As for “temporarily and unsustainably low interest rates that are causing the temporarily and unsustainably high asset price.”
It’s not the interest rate so much as the form of financing. When you have an explosion of mortgages with low teaser rates, or negatively amortization, with the assumption of refinancing a few years later with increased collateral value, that smells (and smelled) a lot like a bubble to me.
Professor Hamilton —
I believe you’re looking in the wrong direction … to the Fed as money-stock manager, rather than the Fed as safety-and-soundness regulator.
Asset bubbles are unpleasant when funded by risk capital but disastrous when funded by borrowing, for two reasons. First, the pool of stupid risk capital is much smaller if it’s not levered up by borrowing, so an unlevered bubble stays smaller and bursts sooner. Second, it’s far better for a burst bubble to deplete some fools’ risk capital than to cripple the nation’s financial system.
That’s why we weathered the 1990s’ tech-stock bubble far better than the 2000s’ housing bubble.
Lenders (rightly) regarded tech stocks as weak collateral; so little borrowed money flowed in. In contrast, loan-to-value ratios actually went UP as the housing bubble gathered steam.
That was irrational at the time, not merely in retrospect. By defintion, a rapidly-inflating asset is volatile; and a volatile asset makes weaker collateral. So regulators can reasonably impose more-stringent lending standards on rapidly-appreciating assets.
Such a policy would throttle back asset bubbles, and minimize risks to the financial system, without requiring regulators to evaluate any given asset-price run-up as a “bubble”.
How well would such rules identify bubbles? From the tech bubble’s start to its peak, the NASDAQ stock index rose perhaps 300%. From the housing bubble’s start to its peak, Los Angeles housing prices rose by 285%. This data, available at the time, made it clear that the latter was no better collateral than the former.
If the interest rate is blunt for bubbles, why is it precise for inflation? Of course, it is not, and works only by slowing the economy.
But in fact, the interest rate is much more appropriate for bubbles than for prices because an essential element of bubbles is easy credit. In fact, one way of the Fed’s determining whether we are in a bubble is to look and see whether or not they are offering money on absurdly low terms. Like right now, for example, when banks can finance their positions at zero, perhaps we have a bubble in activities in which they trade.
A workable and completely mechanical way of getting the Fed out of the bubble creation business would be to simply including asset prices in an expanded price index. Then they would accidentally mute bubbles in their eternal quest to micromanage inflation.
Still, I agree with Steve Kopits’ comment here,
“While the housing bubble was plainly visible, the issue, from my perspective, was not the price of housing per se, but rather the debt incurred on the back of inflated values. That turned out to be enormous, up to 40% of GDP. It is this indebtedness, not the housing price crash, which is crippling the economy. The Fed, to all appearances, stood idly by while America got in over its head. In retrospect it is clear the Fed should have intervened.”
The Fed has REGULATORY powers as well as monetary powers.
Monetary policy is too blunt of a tool for use in popping bubbles. The tight monetary policy (on top of contractionary fiscal policy) led to the 2000 recession that led to the loose monetary policy.
We had a Fed totally bought into the notion that the “free market” could self regulate. The Fed has kept the regulatory tools locked away until the recent crisis. The Fed could have maintained requirements for loan collateral or raised them when they increased the money supply. Loose money and no regulations encourages rank speculation. Loose money needs to be accompanied by tighter regulation so that money is invested in sustainable projects rather than speculative bubbles with the allure of unsustainable short term profits.
Timing is another thing to worry about. Greenspan came to the conclusion that interest rates should be increased slowly, because he was worried raising rates quickly is disruptive to financial markets and could cause financial accidents. (does he know more about the huge derivatives markets than he admits to?). Note that he wasn’t worried about the impact on the real economy, at least once he decided it was time to start raising rates.
So with ZIRP, quarter point hikes and 8 Fed meetings a year, it would take a whole year to get to 2% if they started today.
So in addition to their annoying habit of underweighting misbehaving prices, giving weight to Chinese products, or redefining things as “assets” in the inflation index, they are also ignoring all the financial bets out their on near zero interest rates.
In Fed land we have hedonistic inflation adjustments, health insurance is 4% of CPI, but somehow the price went to $6k a year(but median income is not $150K), houses are assets but not a cash flow problem, and now we have oil, soybean and pork belly assets, instead of dreary commodities.
We can probably live with that(but why?), but then next we will find out what derivatives are very bad, maybe on the order of AIG CDS. Anyone insuring against interest rates moves out there?
JDH,
1) Weak underwriting standards and the “Greenspan Put” were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed’s asymmetric monetary policy. Remember, the underwriting standards were ulitmately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end. I can tell you for a fact that the likes of New Century adjusted their standards directly as a result of how much paper they could originate given the level of demand for their securitizations.
2) A true bubble is one where asset markets and the real economy enjoy a self-reinforcing dynamic. Thus, over-valuation is not, by itself, sufficient to define a bubble. It is over-valuation that leads to a real-economy response which leads to further over-valuation. The Fed, therefore, need not watch valuations. Instead, it needs to pay attention to real-economy dynamics which it has set in motion through monetary policy.
Prof. Hamilton: “MacGee argues, and I agree, that weak underwriting standards in the U.S. were a bigger problem than the low interest rates.”
But couldn’t one argue that excessively loose money begets weak underwriting? It was the pursuit of what would be considered normal yields in other periods that created the demand for subprime-backed bonds popular. Those bonds, and even the CDO bonds, really did not offer fantastic yields, simply more than the sub-5% Treasuries were paying. The subprime->CDO machine was definitely demand driven.
And it was the loose money that allowed the massive leverage of the investment banks and some hedge funds.
You hear so many people who say that interest rate policy should take into account asset bubbles these days. I completely disagree.
And so did Friedman and Schwartz, at least in their Monetary History. On page 291 of the Monetary History, Friedman and Schwartz consider the difficulties raised by seeking to make policy serve two masters:
“There seems little doubt that, [beginning in 1927] had it been willing to take such [contractionary] measures, it could have succeeded in breaking the bull market. On the other hand, if it had single-mindedly pursued the objective implicit in its 1923 policy statement of promoting stable economic growth, it would have been less restrictive in 1928 than it was and would have permitted both high-powered money and the stock of money to grow at something like their usual secular rates. In the event, it followed a policy that was too easy to break the speculative boom, yet too tight to promote healthy economic growth.
In our view, the Board should not have made itself an arbiter of security speculation or values and should have paid no direct attention to the stock market boom, any more than it did the earlier Florida land boom.”
Not only do they dispute the view that policy was too easy during the stock bubble, they actually argue that it should have been even easier. And this despite that fact that they acknowledged that easy money helped fuel the Florida land boom. Their Monetary History suggests that the Fed was right in not abandoning inflation targeting to focus on the housing boom in 2003-06.
Any doubts about this interpretation of the Monetary History are erased in the final paragraph, where (on page 298) they summarize their argument:
“The economic collapse from 1929 to 1933 has produced much misunderstanding of the twenties. The widespread belief that what goes up must come down and hence also that what comes down must do so because it earlier went up, plus the dramatic stock market boom, have led many to suppose that the United States experienced severe inflation before 1929 and the Reserve System served as an engine of it. Nothing could be further from the truth. By 1923, wholesale prices had recovered only a sixth of their 1920-21 decline. From then until 1929, they fell on the average of 1 percent per year.”
Thus, as long as the overall inflation rate is under control, the Monetary History says one should ignore asset price bubbles.
Just how good it government regulation and oversight? Let’s look at only one to see how effective the government is at this task. Below are quotes from the government concerning OFHEO.
Office of Federal Housing Enterprise Oversight
Annual Budget: $66 million (2008)
OFHEO was established in by the Federal Housing Enterprises Financial Safety and Soundness Act of 1992.
As the primary regulator of the two GSEs, the OFHEO is responsible for supervising their operations and ensuring their stability, capitalization, and compliance with legal requirements and standards.
The Act that created OFHEO implemented a regulatory oversight structure for Fannie Mae and Freddie Mac, dividing regulation to address two functions: financial safety and soundness (OFHEO), and the federal governments affordable housing mission (HUD).
Okay, now let’s see the government’s comments after the failure Fannie and Freddie concerning OFHEO’s regulation.
In the wake of the massive accounting scandals in recent years (and OFHEOs inability to prevent or control them), lawmakers have been more willing to approve oversight legislation.
Although the GSE scandals of 2003 and 2004 provided ample reason to increase the regulatory power of OFHEO…..
Only in government does it make sense to use the fact that the utter failure of a $66 million regulatory agency as justification to give it more money. In the Bazaro world of government success means failure and failure means success; only in government is it SOP that success is punished while failure is rewarded.
Professor, you can’t be serious that you believe the answer to our current crisis is more money thrown at government regulation?
“I suggest watching commodity prices in the months ahead as one practical guide for acting on that wisdom.”
Another candidate of guide is nominal gdp, as Scott Sumner always asserts.
Here is my preliminary attempt to incorporate nominal gdp into Taylor rule. This modified version urges FED to act more quickly and boldly than original Taylor rule, not to mention actual FF rate.
If the Fed isn’t there to take away the punchbowl when the party gets carried away, then what is it good for?
And yes, I did short stocks in the late 90s and made a good bit of money. If I could have figured out a way to short housing, I would have done that too. The only problem is that every time short selling makes sense in a big market, the regulators decide shorting is nefarious and work to put restrictions on it.
How’s this for a rule: whenever Prof. Shiller writes a book pointing out that something-or-other is in a bubble, we call it a bubble and work to put a lid on it. He seems to have a much better track record at this point than the Fed.
It’s worth noting that the interest rates were kept low until the 2004 election, then spiked.
The decision to keep interest rates low, frothing the economy, for the 2004 elections should raise questions about whether the Fed acted in its proper role at that time or acted politically to influence the 2004 election.
Mark
Shall we conclude that governments indebtness flirting with the Ponzi ceiling of 100 %,a worldwide banking system mainly insolvent,financial gearings of the same are not a monetary phenomenon?
Shall we read that better supervision of the financial markets,better assessment of banks risks would have been the cure?
No in 1929 1934 the capitalist system is working in full integrity. It takes its losses private.
The best cure for bubbles is to the chips fall where they may once they have finally been pricked by the inevitable mismatch between hype & reality. Since the LTCM bail-out of Wall Street, the ubiquity of the Greenspan/Bernanke put has prevented normal lessons being learned by market participants. The only proper policy response to the imminent bankruptcy of AIG, Citi, BAC was to (a) let it happen and to (b) vigorously announce as much and just as vigorously denounce any alternative. The result we have now is that every hedge fund–which is all that AIGFP, MER, GS, & MS were at the time–must now be bailed out once bonuses may not meet expectations.
No, you need only one figure, monetary flows (MVt). Go on you interest rate freaks, I love making money off of your flawed philosophies.
Rather than bubble, just call it a credit cycle. There is plenty of good serious analysis even if mostly not from the recent academic side. Do they exist? Of course. Can you even understand where you are on the cycle without reference to them? No.
Start with Minsky, Bob Barbera, Soros, Add Shiller for some good behavioral flavor. ..the serious list goes on. Then dont forget some basic Hicks Hanson CAPEX cycle and excess capacity issues for a richer cycle.
Are rates a blunt tool? Of course. So think about direct credit oversight as most experts I respect like Soros do. As he points out, back in the day then there was a bank lending sector, the Fed could suggest lending restraint to some overheated sectors obviously in a bubble.
Not impressed with your “why isnt any bubble direction traded away” argument. Many cycles have reinforcing fundamentals or “reflexivity” in Soro’s term. It is perfectly logical to bet on further excess (or collapse)rather than the reverse
For me, the defining feature of a bubble is positive feedback.
Under normal conditions, markets are characterized by negative feedback. When prices are too low, people buy; when prices are too high, people sell. This negative feedback tends to drive prices back to their fundamental value.
Not so in a bubble. In a bubble, rising prices create buyers. The mechanisms for this fall into three categories.
First, positive feedback is often the consequence of irrationality in the market. Greed; self-delusion; unjustified extrapolation; caring more about relative performance than absolute returns; conformism; confusing the improbably with the impossible; and other persistent behavioral flaws lead inevitably to bubbles.
But one does not have to invoke irrationality to explain positive feedback. Confronted with an incipient bubble, the rational response from a professional trader is to ride the bubble, not counter it. The reasons are various short-term incentives, asymmetric outcomes, incomplete information, firm-wide pay structures, timing issues, agency problems and so on but the outcome remains the same. Yet for some reason, non-professional traders simply do not understand this.
Third and most potent is what George Soros calls reflexive feedback. Under certain circumstances, rising prices can actually improve the fundamentals underlying those very prices. For example, a currency strengthening acts to tighten monetary conditions, decreasing inflation expectations and setting the stage for further appreciation.
Whatever the mechanism, the fact remains that once positive feedback takes hold, it is very hard to displace. And it is nave to expect the market to do so, smoothly and efficiently, on its own. Thats why the central bank needs to intervene.
A few addenda:
I concede that given enough time, market prices will eventually return to their fundamental values (if something cannot go on forever, it will not). But the path thereto will be suboptimal there will be a wasteful misallocation of resources on the way up, and a painful contraction of credit on the way down, with negative consequences for the real economy. It is to avoid these negative consequences that the central bank needs to intervene, preferably early.
Also, Id like to recommend David Pearsons comment at 6:26am; both his points are spot on.
For further reading, I describe in detail why its rational for a trader to ride a bubble and not fade it, here: http://meta-finance.blogspot.com/2009/09/bubbles-and-rational-trader.html . I talk at length about the types of feedback in financial markets (especially bubbles), here: http://meta-finance.blogspot.com/2009/10/feedback-in-financial-markets.html . And I talk about the Feds role in identifying bubbles, here: http://meta-finance.blogspot.com/2009/11/identifying-bubbles-is-easy.html . Thanks for reading!
The Fed is effectively a government agency because of its source of funds, roles, and links with the Treasury. The Fed staff is good at a lot of things, but not at taking counter-trend financial action. If they were good at that, they would be in a hedge fund somewhere. Secondly, Canada has had no banking crisis. It is the model for avoiding bank driven bubbles and crises. We just need to copy Canada’s regulatory environment for financial institutions and the US will get an order of magnitude reduction in bank driven bubbles and crises.
Since we are talking about Soros and reflexivity, it is worthwhile to note that Soros made a billion in 2008 being short financials.
So if the small US saver/investor wants to be financially successful in bubble finance, the right way to do it is wait for the bubble to pop, then reflexivity says go short and power the bubble down.
Plus this gives the Fed and Treasury something to do.
Canada’s real estate market may be currently approaching bubble territory in some regional markets.
If Canadian real estate markets follow some hypothetical commodity boom and then at some point correct sharply as terms of trade inevitably deteriorate, are the markets simply oversold on a cyclical basis or in bubble territory?
The role the Fed seems to have assumed is responding to the opposite of a bubble (which is irrational optimism inflating asset prices relative to fundamentals).
The Fed is attempting to fight the opposite economic issue, which is panics, i.e. irrational pessimism deflating asset prices relative to fundamentals. This is the role it served in response to a threatened run on money market funds, it is the role it served in entering into the commercial paper market, and it is, presumably the role it is engaged in now by buying up $1.25 trillion of agency backed mortgage backed securities.
The case that the Fed makes a good panic fighter is mixed. But, it is a different role than fighting bubbles. Rather than selling short, it is trying to buy low and sell high, which is considerably more conventional. And, there are theoretically a variety of ways to distinguish between a bubble collapse and a panic (e.g. panics usually don’t follow a long run up in asset prices), although both involve dramatic plunges in asset prices.
The Fed seems to have had more success in preventing or curtailing panics than in managing economy wide bubbles.
RICHARD G. ANDERSON, V.P., Federal Reserve Bank of St. Louis: “…They “ECB” justify the “RESERVE” requirement as assuring that banks maintain a PRUDENTIAL LEVEL OF CLEARING DEPOSITS, as you write.”
“Today, with bank reserves largely driven by bank payments (DEBITS), your views on bank debits and legal reserves sound right”
SEE: Member Bank Reserve Requirements — Analysis of Committee Proposal, February 27, 1938 – declassified March 23, 1983…..In 1931 this committee recommended a radical change in the method of computing reserve requirements, the most important features of which were
(2) “Requirements against debits to deposits”
(5)”the committee proposed that reserve requirements be based upon the turnover of deposits”
Scott T. Fullwiler:
(1) “Without reserve requirements, banks hold non-interest-bearing reserve BALANCES only to SETTLE PAYMENTS such as checks drawn on customer accounts or Fedwire funds transfers for direct payments to other banks or the Treasury, or as SETTLEMENT OF NETTED CLEARINGHOUSE TRANSACTIONS”
(2) “In order to avoid the Feds overdraft charges (discussed in Fullwiler 2003), banks desire to hold sufficient reserve balances to SETTLE THEIR NET PAYMENT COMMITMENTS for the day”
Dr. Leland James Pritchard, PhD, Chicago 1933, MS, Statistics…”But we do know that to ignore the aggregate effect of money flows on prices is to ignore the inflation process. And to dismiss the concept of Vt (THE TRANSACTIONS VELOCITY OF MONEY, BANK DEBITS), by saying it is meaningless (that people can only spend their income once) is to ignore the fact that Vt is a function of three factors: (1) the number of transactions; (2) the prices of goods and services; (3) the volume of M.”…”ALL the DEMAND DRAFTS drawn on these institutions CLEAR THROUGH DDs except those drawn on MSBs, interbank and the U.S. government” (G.6 release, debit & deposit turnover)
Contrary to economic theory, and Milton Friedman, monetary lags are not long and variable. The lags for monetary flows (MVt), i.e. proxies for (1) real-growth, and (2) inflation, are historically, always, fixed in length.
Rocs in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram).
Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired rocs in monetary flows (MVt) relative to rocs in real GDP.
Mathematically, economic prognostications are infallable.
ohwilleke
“The Fed seems to have had more success in preventing or curtailing panics than in managing economy wide bubbles.”
I wouldn’t break out the champagne and pop the cork yet. The world now has a sovereign debt bubble, due to repeated government mopups of these recurring boo-boos.
One of the possible outcomes of the Schrodinger Wave Equation, which I’ll offer up as a counter point to Keynes, is “We are all dead, we just don’t know it yet.”
The probability of the wave equation collapsing on this outcome is becoming less than negligible.
To answer the question in the title, yes, of course the Fed should be “the nation’s bubble fighter”, or at least one of them.
Its twin mandates are supposed to be full employment and economic stability (or is it only currency stability?). I find it hard to think of anything less conducive to stability than a big bubble, can you?
It is certainly true that while a bubble is inflating, it helps the Fed fulfill its full-employment mandate. Unfortunately, the bubble-deflation stage isn’t nearly as benign for employment.
Moving on to the question of what low Fed policy rates contribute to the development of bubbles, as I understand it:
First, the low rates lead to reckless borrowing for speculation in dot-com stocks or real estate or whatever the bubble du jour is (also borrowing for unsustainable consumption).
Second, for those with money to manage (such as pension-fund managers), it leads to a desperate search for decent interest rates and, at least in recent years, an unfortunate tendency to fall for sales pitches that understate the risks of “new and improved” fixed-income investing opportunities like tranched mortgage-backed securities.
The whole mortgage-securitization craze was driven by this search for higher interest rates by pension-fund managers, insurance company investment managers, and people like that, who were eagerly eating up those bundled mortgage products. Or that’s what I’ve read, anyway.
The Fed, a bubble fighter? Are you kidding? Does it make sense to promote yuorself as a spoil sport?
Meanwhile, equities are back to overvaluation:
http://raphaelkahan.blogspot.com/2009/12/december-stock-market-update.html
Cedric says
“wait for the bubble to pop, then reflexivity says go short”
right, thats what i did, sold my only house too.
If you want to make more than 6% peryear over decades and get hammered every downcycle you will have to invest on the cycle, and time it to some degree. Don’t have to be perfect, your timing can be really off and still be worth a lot more than zero.
What the Fed actually needs to do most is first lean against the bubble upside. And stop babbling about how they cant outsmart the market. A lot of bubbles look pretty obvious unless you are a fool of the efficient market variety.
Eliminating fractional reserve banking (and the Fed)ought to be an effective bubblecide. *gasp* It might even smooth out the business cycle!
Yes! The foxes should always guard the henhouse!
There is sign of high inflation now from the massive speculation in food price. For example, in China, garlic is up by 200% in less than one year from Chinese speculation on physical inventory for expectation on the price increase. Surely, if the food price speculation spread, the global economy would face at least to stagflation or at most to hyperinflation.
Loosening policy and low interest worldwide are the main reason of speculation in every price including stock prices, real estate prices, commodities prices, etc. I think all central banks will fail to control inflation and the global economy will end with stagflation or hyperinflation in 2010. Now all central banks must tighten monetary policy now.
A long post and even longer comments, so how about the unconventional: bubbles are not bubbles at all, but economic sectors that are retaining their value while the rest of the economy is falling.
If you are outside of the bubble, then the bubble appears to be rising, but only because the rest of the economy is actually crumbling away. The economic statistics won’t tell you that, but the psychology of the situation will affirm that.
If we presume that the underlying economy is crumbling beneath us, then we seek a place to hold on to whatever value we have. Over the past decade, we have had dot coms, housing, stock market, and now gold bubbles. These were attempts to put whatever value of wealth we have into something that won’t crumble along with the rest. This is totally contrary to our present thinking in which the sun revolves around the earth.
Just ask yourselves whether or not these bubbles are concomitant with the significant economic strains of moving from a producer nation to a consumer nation to a debtor nation. We seem to be approaching the point where even the government disregards debt as an issue because the currency has no basis in reality other than the Fed saying it does. Since the private sector has been continuously undermined, the government creates the illusion of propping us up with ever increasing amounts of currency that loses its value globally.
So, again, rather than viewing these valuation shifts as bubbles, you could view them as bridges over an enlarging crater. When the last bridge is crossed, you have free fall. That’s stability of a sort.
Okay, back to deltas, etc.
Great article, and very accurate. A lot of people think the velocity of money is the safeguard against coming inflationary price increases, but that’s just ridiculous. The Fed is using quantitative easing in an environment that demands exactly the opposite.
Here are some of my thoughts…
http://bit.ly/Fed_destroys_dollar
Outstanding discussion! I very much appreciated the contribution by Meta Finance. I also believe that markets will return to fundamental values.
There are tools to sense system “positive feedback” and to neutralize those feedbacks. But there is a reluctance to use those tools when they would be most effective (when the feedback has first been noticed!) Initially, a great number of investors are realizing paper profits and a few are realizing real profits from the positive feedback. Nobody likes a “damp rag” on a party fire. But the outcome hurts far more than the investors that are part of the bubble phenomena.
If the Fed were successful in quashing the bubble, they would be criticized for both acting too cavalierly and for interfering with the “rights” of investors to make profits. People will argue that government has too much power and are interfering where they should not be. No one would be protecting the Fed from these criticisms because most of the people that suffer from collateral damage of the collapse don’t even recognize that they were threatened.
And this is the real dilemma for the Fed.
The US government is hardly in the position to multi-task . . . best to focus on the national debt. . . while adhering to the provisions of the US Constitution.