The Fed Is Still Way Out to Lunch on Financial Bubbles

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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.