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Home Publications Blogs Beat the Press The Fed Is Still Way Out to Lunch on Financial Bubbles

The Fed Is Still Way Out to Lunch on Financial Bubbles

Tuesday, 05 March 2013 09:20

The Federal Reserve Board disastrously missed and/or ignored two huge bubbles in the last decades: the stock bubble in the 1990s and the housing bubble in the 2000s. The collapse of both bubbles led to recessions from which it was difficult to recover. Neil Irwin inadvertently tells us today that the Fed is still utterly clueless when it comes to dealing with bubbles.

The problem is that, at least according to Irwin's account, no one at the Fed seems to understand how bubbles hurt the economy. On the one hand, he presents the views of Fed governor Jeremy Stein, a bubble hawk, who he tells us:

"argued in a Feb. 7 speech that there are already signs of overheating in the markets for certain kinds of securities, including junk bonds and real estate investment trusts that invest in mortgages. And if those or other potential bubbles get so large that if they popped the whole U.S. economy could be in danger."

By contrast we have Fed chair Ben Bernanke and vice-chair Janet Yellen, the latter of whom he quotes as saying:

"At this stage there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability."

Unfortunately, the concern about financial stability and discerning bubbles in a wide array of economic data completely misses the point. First, financial instability is not what caused our problems in either 2001 or in the current downturn. As much fun as it is to see the Fed chair, Treasury Secretary and other important people sweating over the collapse of huge financial institutions, this crisis was very much secondary to the country's economic problems. We know how to paper over a financial crisis, which the Fed eventually did (as did the European central bank), the hard part is replacing the demand that had been generated by a bubble once the bubble has burst.

This directly leads to the second point. The bubbles that we have to worry about are not hard to find. Suppose there is a huge speculative bubble in soy beans that pushes their price to 20 times their normal level. This could be bad news for people that like soy beans and derivative products. It may also be disastrous for producers in the industry if they get caught on the wrong side of things. However, the collapse of this bubble will have minimal impact on the economy. If for some reason our bubble watchers at the Fed failed to notice the rise in soy bean prices, the problems caused by its eventual bursting will not sink the economy.

On the other hand, the problems caused by the collapse of the stock and housing bubbles did sink the economy because the bubbles were actually driving the economy before they burst. The stock bubble led to a record share of GDP going to new equipment and software investment. This was due to the fact that investors were willing to pay billions of dollars for the stock of companies that did not even have a plan for ever making a profit. In addition, the $10 trillion in bubble generated stock wealth created a consumption boom, driving the savings rate to what was then a record low.

The same thing happened with the housing bubble. Record high house prices caused the construction share of GDP to rise by more than 50 percent at the peak of the bubble. The $8 trillion in ephemeral housing equity created by the bubble led to another consumption boom with the saving rate falling to near zero. 

When these bubbles burst, there was no alternative source of demand to replace the demand that had been generated by the bubbles. However, because these bubbles were driving the economy, they were not hard to detect. It was only necessary to look at the GDP data and to recognize that equipment investment and consumption were out of line in the days of the stock bubble and housing construction and consumption were out of line in the days of the housing bubble.

There is no remotely comparable imbalance in any component of final demand that could currently be the result of a bubble in junk bonds, if one exists. (My vote is yes.) That means if this bubble bursts, then holders of junk bonds lose money. So what? That will not lead to plunging construction, consumption, or investment. People make and lose money every day in financial markets.

If the folks at the Fed, and the people who cover the Fed in the media, still cannot see the difference between the sorts of bubbles that pose real risks for the economy and the bubbles that only pose a risk for those speculating in narrow markets, then we have learned nothing from the economic crisis.

Comments (12)Add Comment
written by Nick, March 05, 2013 9:14
Dean says there is a bubble in junk bonds...where can I short them?

Bloomberg article
written by Peter K., March 05, 2013 10:27
Mr. Baker did you see this?


"Taylor echoed criticism of scholars including Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who say the Fed helped inflate U.S. housing prices by keeping rates too low for too long. The collapse in housing prices led to the worst recession since the Great Depression and the loss of more than 7 million U.S. jobs."

I understood your criticism of the Fed wasn't that they kept rates too long for too long (there was a housing bubble in Europe as well) but Greenspan and the Fed denied it's existence. As I understood it you have said Greenspan should have discussed the dangers of the bubble on a daily basis instead of raising rates, no?
But what about the fraud?
written by edward ericson jr, March 05, 2013 1:05
Dean, you could not be righter in pointing up the Fed's bubble ignorance. But you omit a key ingredient common to the RE & junk bond bubbles of the late '80s, the internet=profits bubble of the early 2000s and the subsequent housing bubble and crash.

Over time the culture of fraud that developed and nurtured these bubbles has been less and less prosecuted or remarked upon. And so that culture continues. Whether it's manipulating commodity prices (which Krugman says can't happen) or pushing junk bonds on yield-starved and gullible public pension managers or hiring shoe salesmen to stuff subprime loans down first-time homebuyers' throats, so those doomed loans can be sold to gullible pension managers, the game is always the same.

It will ever be the same until someone starts putting the scumbags in jail.
written by JSeydl, March 05, 2013 1:11
Great post here. Lots of wisdom and shelf life.
written by watermelonpunch, March 05, 2013 4:39
no one at the Fed seems to understand how bubbles hurt the economy

we have learned nothing from the economic crisis


Many have learned. And many don't care that it hurts the economy.

A lot of people have learned that they can make bundles of money in bubbles, and, well, let the rest of the economy go to hell in a hand basket - they got theirs.

They like bubbles, I think.
They like bubbles, I think.
written by JP, March 05, 2013 7:56
Yes, they certainly do and the more they can inflate them the better they like it. Creating and taking advantage of bubbles is just one of the tools and I think it is a symptom of a deeper malaise.

Some may call it ego, exceptionalism, privilege, or entitlement but our culture is immersed in these traits. We prefer to ignore and deny that we, as individuals and as a society, possess these tendencies of telling ourselves that "I'm special!" or "We're special!" Nevertheless they can be found from the top of our political structure, throughout our corporate structures, institutional structures, and they are way more common in our societal structure than we would like to admit. We as a society actually take pride in our exceptionalism!

Rules and laws be damned. They do not really apply to "ME or US!"
written by urban legend, March 05, 2013 10:16
What would have happened to the real estate bubble if the Office of the Comptroller of the Currency, presumably in a case of regulatory capture, had not asserted a highly questionable interpretation of Federal preemption to prevent many state attorneys general from going after the national banks for fraudulent lending practices? Would the same number and aggregate value of mortgage-backed securities have been issued if the bubble had been deflated in the 2003-2005 period by legal actions stopping the worst practices? If the OCC had done its job and allowed state enforcers a level playing field to prevent local fraud by both state and national banks, would it have even mattered what the Fed did?
Money Creation is the Problem
written by LXDR1F7, March 06, 2013 5:29
The ability of banks to create money is what allows them to invest excessively in speculative markets. If their power to create money is removed we have a level playing field with all other corporations and speculation declines.

written by bakho, March 06, 2013 6:59
The Fed does indeed like bubbles. There is strong evidence that the housing bubble was not merely allowed by the Fed but it was encouraged by Greenspan and his Fed. The Bush administration was a major cheerleader for the housing bubble with Bush himself as Cheerleader in Chief.

Greenspan was a Randian anti-regulator who dismissed the Fed regulatory powers and almost depended solely on the monetary powers. The anti-regulators complain that the Fed cannot act to deflate a bubble without harming the whole economy. This is precisely what Greenspan did in 2000 as he tried to use monetary policy rather than regulatory policy to address the stock bubble. The result was a recession and jobless recovery that Greenspan tried to address by inflating a housing bubble.

Bubbles can be addressed without hammering the rest of the economy with high interest rates by increasing collateral requirements to reduce leverage. This keeps bubble speculators from crowding out borrowers for legitimate investments. The chainsaw regulators are less effective because they ignore an important tool for preventing bubbles.
written by skeptonomist, March 06, 2013 8:39
The late housing bubble was not a simple asset bubble, or even a normal speculative bubble as in the stock market. Real estate bubbles have always been commonplace, but they are usually regional in nature. What set this bubble apart was the extent of international reliance on credit-default swaps to hide the magnitude of the exposure to excessive leverage and just plain fraud. CDS's were largely responsible for the absurd overratings of MBS's. Literally no one recognized the severity of the financial problem.

Although Dean and some others recognized that the size of the bubble indicated danger, its implications for finance and the general economy were not at all obvious. The Fed can't chase down every asset bubble.
It is still not clear that there is a great excess supply of houses - some reputable economists have taken the contrary view. An asset bubble does not necessarily produce an excess supply - a bubble in gold (which probably exists at the moment) does not mean that the supply of gold is increased much - such bubbles collapse for other reasons.

My point is that such bubbles must be prevented from forming in the first place by regulation of finance, not by having a superhuman Maestro blow a magic whistle when he detects an incipient bubble (if he causes the bubble to collapse at its peak, he just gets blamed for a recession). Economists should have some idea by this time of what constitutes excessive leverage - this is really what causes the danger in bubbles. Instead of realizing that Alan Greenspan was determined to reduce regulation and expand leverage, until around 2000 economists cheered him on along with the media, as the Maestro who had the economy under control.
written by liberal, March 06, 2013 10:19
skeptonomist wrote,
It is still not clear that there is a great excess supply of houses - some reputable economists have taken the contrary view. An asset bubble does not necessarily produce an excess supply ...

But the bubble wasn't, at its base, in houses, but rather residential land.

Bubbles are much more apt to occur in goods of fixed or nearly fixed supply.

That said, totally agree with your point about financial regulation. Though IMHO much of it shouldn't be regulation as normally thought of, but rather e.g. disallowing the creation of CDSs, which serve no useful social purpose.
Response to Brad DeLong?
written by Anthony, March 06, 2013 1:07
Coincidentally, Brad DeLong has a post this morning saying just about the opposite of what you argue here: the housing bubble did not crash the economy, the subsequent financial crisis did. In fact, he suggests the distortions caused by the bubble were being "smoothly" (as he puts it) absorbed by an adjusting economy; it was the financial crisis that brought on the recession.

You have tackled these kinds of claims before, but I have never seen them made by an otherwise astute economist--and someone who normally agrees with you. Will you break your rule about commenting on blog posts and respond to DeLong?

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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.