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Home Publications Blogs Beat the Press Central Bank Battles Against Bubbles

Central Bank Battles Against Bubbles

Friday, 11 July 2014 05:41

In a Wonkblog post Matt O'Brien discusses central bank efforts to deal with bubbles. His starting point is the decision by the central bank in Sweden to begin raising interest rates in 2010, ostensibly to head off the development of a bubble there.

There are two points worth noting here. First, it is difficult to imagine what the central bankers were drinking in Sweden when they decided to start shooting at bubbles. A bubble that threatens the economy is a bubble that moves the economy. If there is a bubble in Uber stock or the price of hops, there is little consequence to the economy when the bubbles burst.

The crashes of the stock bubble and the housing bubble led to recessions because these bubbles were driving the economy. This was easy to see in the data in both cases. In the first case, the investment share of GDP hit the highest level in more than two decades as people were able to raise billions in IPOs for utterly nonsense dot.coms. Consumption surged to then record shares of income as the stock wealth effect caused spending to surge. This boost to the economy disappeared when the bubble burst.

There was a similar story with the housing bubble. Residential construction hit a record share of GDP, roughly 50 percent above its average over the prior two decades. Consumption surged to an even higher share of income, driven by the housing wealth effect. And, when this bubble burst we got the Great Recession.

There were no obvious distortions in the Swedish economy when its central bank started shooting at bubbles. Its savings rate was relatively high and the country had a huge trade surplus (as opposed to deficits in bubble driven economies like the U.S. and Spain). The bubbles that really matter are not hard to see. Economists like to pretend otherwise since almost all of them missed the last one, but that reflects the competence of economists, not the inherent difficulty in recognizing bubbles.

The other point is that central banks do have many tools other than interest rates to attack bubbles. My favorite is talk.

I know it doesn't sound sophisticated and it's not terribly mathematical, but I suspect it would have a very large impact on the housing market if Janet Yellen were to say that she thought house prices were over-valued and that the Fed would be prepared to take steps to bring prices in line with fundamentals. Note that I am referring to an explicit warning backed up by Fed research, not a mumbled "irrational exuberance" subsequently qualified by incoherent gibberish. I would certainly take such a warning seriously if I was thinking of buying a house.

I know this view is dismissed by economists, but it's hard to see the downside of trying this path. The worst I've heard is that this could damage the Fed's credibility if house prices didn't fall. Given that we have lost many trillions of dollars of output and millions of people have seen their lives ruined from the collapse of the housing bubble and the ensuing recession, the risk of the Fed's credibility seems a small price to pay in such circumstances.

Comments (21)Add Comment
written by dax, July 11, 2014 6:31
"but I suspect it would have a very large impact on the housing market if Janet Yellen were to say that she should thought house prices were over-valued and that the Fed would be prepared to take steps to bring prices in line with fundamentals."

Since the main thing the Fed can do is raise interest rates, then we're back to square one, no? Unlike Dean I think the warning will have little permanent effect, and so the Fed either has to carry through and raise interest rates or simply throw in the towel and lose all credibility. (Now the Fed could of course do other things besides raising interest rates, but the things it would have to do - like demanding much larger deposits on purchases of houses - are politically intolerable.)
written by skeptonomist, July 11, 2014 8:48
Apparently Dean thinks that if Greenspan had listened to him in 2002 when he and some others first noticed the housing bubble, and made some magical remarks, this would have harmlessly deflated or stopped the bubble. In the first place, there is not a chance that Greenspan would have done any such thing. It was the deliberate policy of the Fed to encourage housing, and in 2002 this policy was apparently just beginning to have effects and to turn the economy around - they weren't going to reverse the policy then. In 2004 the Fed did start to raise federal funds rapidly - did that deflate the bubble harmlessly? Encouraging housing was probably a mistake in the first place, but this is the sort of thing that central banks are supposed to do to control the economy. There was a huge housing boom after WW II which did not result in a crash, and authorities probably thought they could do more of the same. The difference after 2002 was the unregulated financial structure, but Greenspan himself had done everything he could to allow looser banking.

In the second place, who would have listened to Greenspan's remarks? Big banks and other lenders were starting to make money hand over fist through the dodgy loans. Does Goldman Sachs run its business according to the desires of the Fed Chairman? There would have been plenty of "experts" to counter anything Greenspan said. The low-income people and flippers who were taking out the mortgages they couldn't pay for don't run their lives by Fed pronouncements either.

The Fed chairman doesn't control the economy, either through actual monetary actions or magical pronouncements. Relying on the Fed will only lead to more problems. Bubbles will have to be controlled by tighter regulations and better structures. New Dealers understood this, but their regulations were deliberately abandoned. Dean himself has a lot of good suggestions for better control (how about financial taxes?).
written by bakho, July 11, 2014 10:07
Yellen more or less said that monetary policy was too blunt to address bubbles. Why use monetary policy to create unemployment and tank the economy when better regulation could tighten lending standards on housing or other bubble? Greenspan locked the regulatory tools in the shed and tanked the economy with tight monetary policy in 2000. He did nothing to regulate the abuse and fraud in IPOs or outright scams like Enron.

Inflation everywhere can and should be addressed by monetary policy.
A price bubble in a single sector is best handled with target regulations.
Conservatives and Libertarians refuse to even speak the R-Word. The response of sane economists should be to fly the better regulation flag.
Actually, there was no comparable boom in housing after WW II
written by Dean, July 11, 2014 10:53

I suggest you check the data. residential construction never grew to be anywhere near as large a share of GDP in the decades from 1945-1975 as it did in 2004-2006. And real house prices actually fell slightly instead of rising by 70 percent. Those are huge differences.

And the ability of Goldman or whoever to push mortgages, or more properly MBS, depends on a person willing to buy the home. There was almost no one other than me saying that house prices were seriously over-valued in 2002-2006. If the Fed has said this, then everyone would have heard it and seen that housing was not a safe bet.

And sorry Goldman could not produce any research that would pass the laugh test on this point. I know that many economists are thick as rocks when it comes to economics, but at least a few have passed third grade arithmetic and would have been to see this -- plus they defer to authority.
written by Dryly 41, July 11, 2014 1:45
"The other point is central banks have more tools to attack bubbles other than interest rates. My favorite is talk."

This is back to the sixties. The economists JFK brought into government determined that a targeted "incomes policy" directed at oligopolistic industries such as steel and autos was a better way to stem inflation than "taking away the punch bowel just when the party got going" i.e. putting the country in recession as in 1954, 1958, and, 1060. Walter Heller, James Tobin, Gardner Ackley, Arthur Okun, Robert Solow and others thought so. So do I.

"I know this view is dismissed by economists, but it's hard to see the downside." Agreed.
written by Dryly 41, July 11, 2014 1:58
Actually there were many who saw the housing situation develop early. In September 2004, Chris Swecker, Deputy Director testified before Congress he feared another "epidemic" of mortgage fraud on a scale seen in the 1980's. Ned Gramlich told Greenspan about the danger of subprime mortgages. And there was the tool given to the Fed by 1994 legislation giving the Fed authority to set standards for mortgage underwriting. But Greenspan refused to use that authority. He believed, as he told Brooksley Born, there was no need to enforce laws against fraud as the market would take care of it. He felt people would not do business with fraudsters, so, fraud could never be a problem. Neither did Ben Bernanke use the authority granted to him until long after. When he did act, there was not one subprime horse left in the barn.

This is as poor an excuse as I have ever heard.
It's only talk
written by Squeezed Turnip, July 11, 2014 2:15
Talk is powerful and creative. I agree with Dean, the Fed chair could just explain why in its opinion there is a bubble in industry X. This would certainly make investors more wary, just look at the reactions over the last year or so to various Fed chair pronouncements.

If, as skepto and dax fear, the market for some reason took on a "so whatcha gonna do about it" attitude (which is doubtful), just remember that the Fed writes the rules for its member banks and they do indeed have powers they have not yet used but could to help transmit the message in a language the deniers would understand. Monetary policy (as interpreted by the broader public) is not the only tool of the Fed.

Finally, to think that the Fed will fret over its credibility on an issue like this seems rather unlikely, given that its credibility is already so low that there are very-well-financed presidential candidates that have "get rid of the Fed" as part of their campaign promises. Yellen is a good prognosticator, the best record of anyone on that committee and of any FRB prez. If she pointed out a bubble and explained why it's a bubble, people will listen and steer their money somewhere less risky.
written by Veddicculture , July 11, 2014 6:01
lol, people still consider the 90's stock market boom a "bubble". I just don't see it. To me, that was the information boom+Y2K. Capitalists were aggressive in spending and investing during this phase. Once Y2K past with no incident, they simply lost interest in expansion and there hardly was a recession due to the credit boom. Corporate profits really tell that story. They collapsed in the late 90's as spending was intense. Spent the 00's rebuilding that hopefully(as been mentioned on this site) is over and they will start spending again.

IMO, you battle credit bubbles when credit expansion as a whole gets out of line with inflation. That means the economy is expanding to much for what the actual per capita spending by capitalists actually is. Nobody really thought about it and no calls were made in 2001-2 to slow it down.
The Point Is...
written by Larry Signor, July 12, 2014 9:54
raising interest rates is a very blunt tool, where as Fed-speak can be a very targeted and closely watched tool. A great deal of effort is expended trying to anticipate and understand pronouncements from the Federal Reserve as they generally indicate future Fed policy. Have we already forgotten the "Taper Tantrum"?
written by JayR, July 13, 2014 12:34
Interesting thing is that Dean Baker himself doesn't point to the current US housing bubble that often in his very own Beat the Press blog. Yes the current bubble is not yet as bad as the last one but still....
credit expansion versus inflation
written by Squeezed Turnip, July 13, 2014 2:41
Those are thought-provoking ideas, VedicCulture (love the name!), and it must be that capitalist investment/spending does play a role. But your prescription doesn't really work it seems, when you look at the history. Here's one look at it (I tried other flavors and they gave similar results):

Here's credit against capital formation
written by Squeezed Turnip, July 13, 2014 2:53
still not a home run, but it does show that the last few recessions have been presaged by a drop in capital formation without a corresponding drop in credit instrument liability formation :
Written off economists
written by Dave, July 13, 2014 9:13
I pretty much wrote off all economists when they all refused to confront the coupling of the GSEs and other housing mortgage guarantees with monetary easing.

It is obvious that economists drew overly abstract views of what causes monetary policy to work. Why can't they confront that?

I don't get it.
written by dax, July 14, 2014 6:22
I'm really surprised how many think talk will actually have an impact. "Irrational exuberance" was pretty strong, and only had a short-term impact. Last Wednesday the Fed's minutes read, "Signs of increased risk-taking were viewed by some participants as an indication that market participants were not factoring in sufficient uncertainty about the path of the economy and monetary policy." For the Fed, that's a pretty strong statement, but nobody cared next to the promise that interest rates will remain low.
written by liberal, July 14, 2014 8:49
Veddicculture wrote,
Once Y2K past with no incident, they simply lost interest in expansion and there hardly was a recession due to the credit boom.

Huh? On the planet I live on, there was most certainly a dot com crash-related recession. Was it as bad as the housing bubble-related one? No. That doesn't mean it's not a recession.
written by liberal, July 14, 2014 9:02
dax wrote,
I'm really surprised how many think talk will actually have an impact.

IMHO the key to stopping the housing bubble was for the Fed to actually do its job (well, one of its jobs) and regulate the mortgage industry.
written by Dave, July 14, 2014 4:13
I wonder though, what regulation do you think was too lax that caused the housing bubble? I see no mechanism for regulation to control the effect of very low mortgage rates upon housing prices given the historical context of rates and housing prices.

A lack of regulation certainly allowed the financial industry to get out of control, but nobody has definitively proven that the housing bubble would not have formed and collapsed without those problems. Strong evidence suggests it would have happened anyway,

All you have to do is look at historical data of rates, prices and the existence of the GSEs.

This was the first time in history that everything came together, causing the accepted system, even void of any fraud, to collapse.
Apologies to PK
written by Dave, July 14, 2014 4:17
For obvious reasons. I miss being able to comment on his blog, despite the fact that the NYT opinion page has some really bad actors on it.
Central Bank Battles Against Bubbles
written by pieceofcake, July 14, 2014 11:23
'it is difficult to imagine what the central bankers were drinking in Sweden when they decided to start shooting at bubbles.'

its actually pretty easy to imagine -(nearly as easy as 'easy money')
All it took was a lot of Stockholmer who were getting sick and tired of what they perceived as their real life consequences of the 'easy money'-(not only speculators were ruining their neighborhood - but also 'neighbors' who joined the bubbling game.

But otherwise: 'A bubble that threatens the economy is a bubble that moves the economy'.

and I'm really impressed how you simplify the general Dada of bankers and economists.
The next step could be to think about 'non economical motivations or consequences' -(like the Stockholmers aversion against bubbling up their houses and appartments or the BIS way of looking at IT because Jaime is a Spaniard from Valencia)

AND that would be truly 'holistic'!
(if you know what I mean?)
and about 'the talk'
written by pieceofcake, July 14, 2014 11:45
as nothing seems to be more important -(at least in the US economy) as speculators talking -(about money making schemes aka:'bubbles') - and 'bubbles drive the economy' - talk is most important.
(at least in the US economy)
And if we notice how intense speculators stare at the FED
-(and not at goats) - the only problem which has to be solved to identify which bubbles have big consequence to the well being of the people when they burst.
by the way -
written by pieceofcake, July 15, 2014 2:54
it might be true - 'If there is a bubble in Uber stock or the price of hops, there is little consequence to the economy when the bubbles burst.'

BUT Housing Bubbles are (still) the most efficient 'instruments' to selfdestruct - and who in the world had this stupid idea to use Houses for bubbling?
Not the Germans - that's why they didn#t selfdestruct and became World Champions!
-(okay - just (ch)joking!)

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.