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Home Publications Blogs Beat the Press The Fed Could Try Talking About Bubbles

The Fed Could Try Talking About Bubbles

Tuesday, 27 July 2010 07:04

The Washington Post had an article discussing the debate over how central banks can prevent future economic collapses like the current one. As is its practice, the Post relied exclusively on economists who were not able to see the crisis coming. As a result, it fundamentally misrepresents the crisis as being primarily financial in nature.

In fact, the main problem was that the housing bubble was driving the economy, generating $1.2 trillion in annual demand through construction and housing equity driven consumption. There is no easy mechanism through the economy can replace this much lost demand. That would be the case whether or not the collapse of the bubble was associated with a financial crisis.

The article also fails to list one of the most simple and obvious ways that central banks can combat a bubble: talk. During the run-up of the housing bubble, Federal Reserve Board Chairman Alan Greenspan repeatedly said that everything was fine in the housing market, as did Ben Bernanke, who was a governor at the Fed for most of the period. This helped undermine the case of those who were warning of the bubble.

By contrast, if Greenspan had explicitly warned of the bubble and documented its existance and potential dangers with extensive research from the Fed staff, it may have been effective in containing its growth. The financial industry cannot simply ignore research from the Fed and there was no serious response to the evidence that the Fed could have presented.

There is no reason the Fed and other central banks cannot use the full capabilities of their research staff to attempt to counter dangerous financial bubbles. There is a virtually costless strategy with enormous potential payoffs.

Comments (7)Add Comment
written by skeptonomist, July 27, 2010 8:51
Given that the Maestros of the Fed have the ultimate responsibility for the economy, it is not surprising that they would take the course of trying to counter the recession of 2001 through boosting housing, especially since the situation was still favorable for this in 2001. The boost in housing appears to have been the major favorable result of monetary policy. For them to then suddenly turn around and admit that they have created a bubble is asking too much. People would wonder whether they really know what they are doing, or, God forbid, whether monetary policy is the best way of trying to smooth out cyclical variations. It would not be costless for them.

Dean's claim that the public utterances of the Fed chairman can influence the economy works both ways. Authoritative public reassurances that there is no bubble are supposed to prevent panic, and allow markets to work out temporary imbalances by themselves, which Randians, among others, believe will always happen.
written by skeptonomist, July 27, 2010 9:22
Note also that Greenspan was always a big supporter of degregulation - this was probably a major reason he was selected by the Reagan administration (and reappointed by Clinton?). Is it likely that he would admit that lack of regulation was leading to a collapse of banking? Whatever the Fed researchers might have been finding out about financial problems, if anything, Greenspan must have turned a blind eye to it if it put deregulation in a bad light.
written by anonymous, July 27, 2010 1:17
As a result, it fundamentally misrepresents the crisis as being primarily financial in nature. In fact, the main problem was that the housing bubble was driving the economy...

Yes, but the reason there was a housing bubble to begin with was because of problems like too much deregulation in the financial sector.
Our American Nightmare
written by Scott ffolliott, July 27, 2010 7:19
Our American Nightmare, where we come home every night. An allegoric journey of our soul's descent into one of the circles of Dante's hell
The New Bubble
written by libhomo, July 28, 2010 5:34
I'm surprised nobody is talking about the gold bubble that is on the verge of bursting.
regulatory capture
written by scott, July 28, 2010 9:31
The libertarian in me thinks that this disclosing of information is the principal way gov't should work to regulate business. This coupled with free courts with real liability power based on conventional liability law is more effective, more fair, more constitutional than regulation. Regulatory capture is a problem we can't ignore.

In fact, it's the same sin isn't it Dr. Baker. What you've exposed shows they weren't gonna do anything to tamp the fire. What people too often miss in calling for regulation is that they generally offer indemnification with it. And, it's not wrong to call Socialism.

Again I'd prefer professional rules where applicable. I'm not against regulation, it seems the CFTC works ok, when they're not excluded from markets.

We need to enforce anti-trust laws. Consider subsidies, our Ag. supports creates monopolies where they shouldn't exist. Whereas food stamps don't pervert supply and demand--I find this to be a better program; while WIC must reinforce the monopolies.

There's probably no way to measure what our farm subsidies, which create ADM, Monsanto, Con-Agra and these behemoths that create monopolies where there should be diversity. This is true of firms, and crops. Perhaps we pay a bit less for some food, but quality and variety are limited.

But, what is the cost the subsidy for petro-fertilizer, diesel intensive transnational/transcontinental distribution networks, geneticly engineered mono-culture crops, dead zones in oceans larger than the BP spill, energy-inefficient polluting ethanol? These are all driven and created by our Ag policy.

I like free markets, where they (should) exist. We need to treat professions as such and utilities/monopolies likewise. We need to get wonkish and discuss where we can trim gov't, where gov't is pernicious, and where it is essential. Liberals need to have this discussion, since this can't be a simple dichotomy.

Republicans are so unwilling to discuss this,
"NO" that liberals need to get serious about policy. We can't simply keep growing gov't blindly; we've got to make sensible cuts. Ag policy, dept of education, and many other depts might be more effective if they did nothing but published a magazine with facts, analysis and various success stories.

Presumably all this money is coming from the states anyway. Again, a very small agency could dole out subsidies, check data, compare across the states. But, the more these agencies do, the more they get lobbied.

That's why, sometimes an honest voice of concern, backed with the integrity of an independent gov't speaks it carried tremendous weight.

But, I'll remind you that in the Spring of 07, Bush and Energy Sec. Bodman both declared that oil was short. Now at the time according to both the Petroleum institute and the US dept of Energy we were in a 17 week run of 1million barrels of excess in both oil and refined gas, with refineries running 5-6% below normal capacity. This benefitted oil speculators, two principal actors being Goldman Sachs and BP.
Greenspan's idea
written by FGS, July 29, 2010 1:46
I think it was all financial, and mostly Greenspan's fault for personally encouraging people to take out adjustable rate mortgages. They did, en masse and they started defaulting roughly 3 years later when their payments started doubling. Suddenly, investors panicked that mortgage backed securities really aren't risk free, and they made an old fashioned run on the shadow banks.

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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.