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Sunday, June 15, 2008

Alan Blinder: Two Bubbles, Two Paths

Alan Blinder says there are two types of bubbles, and the Fed should only try to prevent one of them:

Two Bubbles, Two Paths, by Alan S. Blinder, Economic Scene, NY Times: Lately more and more people have been questioning the received wisdom about what a central bank should do when confronted by an asset price bubble. That piece of wisdom ... holds that deliberate bubble-bursting is something between impossible and dangerous — and thus best avoided. Instead, ... the Fed should let bubbles burst of their own accord, and then be prepared to mop up after.

This strategy ... is designed to limit collateral damage to the rest of the financial system, and especially to the overall economy. The Fed executed such a mop-up-after strategy with great success when the tech bubble popped spectacularly in 2000. ...

In taking up these [questions about the received wisdom]..., it’s crucial to distinguish between two types of bubbles. The first, what I’ll call “bank-centered bubbles,” are speculative excesses ... principally fueled by irresponsible ... bank lending. The housing-mortgage bubble was an obvious and painful example. But in other asset bubbles, bank lending plays a minor role, or none at all. The tech-stock bubble was a dramatic example of this second type.

I would argue that the central bank’s proper role is fundamentally different in the two types of bubbles. Here’s why:

When bubbles are not based on bank lending, the Fed has no comparative advantage over other observers in distinguishing between rising fundamentals and bubbly valuations. It may see bubbles where there are none, or fail to recognize them until it’s too late...

Indeed, at the Fed, I recall Mr. Greenspan thinking that he saw a stock market bubble as early as 1995... Fortunately, he did not make the mistake of trying to burst it. ...

That’s the first problem, and it’s a huge one. Here’s the second:

Once a central bank correctly recognizes a bubble’s existence, what is it supposed to do? The Fed has no instruments aimed directly at, say, tech stocks, and practically no instruments aimed at stock prices more broadly. (Those who argued that higher margin requirements would have worked were engaged in deeply wishful thinking.)

Of course, the Fed could have raised interest rates. But why would raising the federal funds rate by, say, two to three percentage points have ended the stock market mania when investors were expecting 19 percent annual returns in the stock market? That much monetary tightening, however, might well have stopped the economy in its tracks. ...

But a bank-centered bubble is starkly different in both respects.

As long as the central bank is also a bank supervisor and a regulator, it is extraordinarily well placed to observe and understand bank lending practices — much better positioned than almost anyone else. ...

And what about instruments specifically aimed at the bubble? ...[T]he Fed’s kit bag is ... stuffed full when it comes to taking aim at bank lending practices. Escalating upward from a sternly arched eyebrow to an outright prohibition of certain types of lending — for example, subprime loans with no documentation...

Finally, regarding inflation, let’s look at the record. The core inflation rate ... was in the 2 1/2 to to 3 percent range in 1995 to 1996, when serial bubble-blowing supposedly began. It has hovered in the 2 1/4 to 2 3/4 percent range in 2007 and so far in 2008. Do you see a rising trend?

There are two main conclusions: First, when bubbles are not based on bank lending, the mop-up-after strategy still looks pretty good. When it comes to bank-centered bubbles, however, there are many more things that a central bank can and should do. But raising interest rates to burst the bubble is probably not one of them.

    Posted by on Sunday, June 15, 2008 at 03:24 AM in Economics, Financial System, Monetary Policy | Permalink  TrackBack (0)  Comments (18)


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