Why Does the Fed Feel Powerless to Identify Bubbles in Real Time?

On the same day that Ben Bernanke made his speech mentioning the dollar, his intellectual blood-brother Don Kohn made one that touched heavily on the issue of asset bubbles. At the risk of over-simplifying the speech, Kohn essentially said that monetary policy is an inappropriate tool for addressing ongoing asset bubbles, and that regulation is the preferable policy option. Oh, and we're not currently observing another asset bubble forming before our very eyes.

His defense against using monetary policy to address bubbles was essentially "gee, it sure didn't work in the dot-com bubble of '99 or the housing bubble of '04-'05". The obvious rejoinder to this argument, of course, is that despite hiking rates the Fed never managed to arrive at a tight monetary setting; Macro Man's nominal GDP indicator suggests that policy remained moderately easy during the late-90's tech bubble and ludicrously easy during the housing boom.

So from that perspective, Kohn's argument is specious at best; the Greenspan Fed never properly applied monetary policy to address asset bubbles!

At least Kohn conceded that the Fed's regulatory policy (i.e., "who? me?") had been, ahem, sub-optimal. And it doesn't seem to be a stretch that regulation should play a stronger role in addressing asset bubbles moving forwards; hell, even requiring mortgage applicants to send in $5.99 and two box-tops from Lucky Charms would significantly raise the reporting hurdle from its 2005 liar-loan nadir.

Still, if Kohn's claim that "our abilities to discern the "correct" values of assets is quite limited", how can the Fed fail to recognize that Nasdaq 1999-2000 was a bubble....

...as was the 2003-05 housing market.....

...and oil last year.....

...but that a less than 10% decline in the value of the S&P 500 in the first few weeks of last year was sufficiently worrisome that it merited a 75 bps inter-meeting cut a mere 8 days before a regularly scheduled FOMC policy decision (which produced a further half-point cut)?

Put another way, why does the Fed feel powerless to identify bubbles in real time, but is evidently highly confident in its ability to determine when asset prices have fallen below equilibrium?

If the Federales are truly concerned about ensuring financial stability, addressing asset price moves in a symmetric fashion would be a great place to start. Because on the evidence of the last dozen years or so, the Greenspan/Bernanke/Kohn is a helluva lot more trouble than it's worth.

Comments

[chap08]

I partly agree with you, but I don't think that identifying (let alone bursting) bubbles is such an easy thing. If you think that the Fed should burst bubbles, then you have to be able to answer the following questions:

1. What is a bubble and what is the difference to over-valuation?
2. At what stage should the bubble be prevented or burst?
3. What is the relative priority of bursting bubbles and other economic objectives e.g. employment?
4. What assets should this be applied to e.g. healthcare stocks, sugar futures, Kansas housing, treasuries, gold?
5. Why should the Fed be better at spotting bubbles than the market? How would they determine if, say, stocks are in a bubble now, when for every hedgie that says they are, I can find one that says they're not?

For my part, I see a big difference between a bubble and a highly leveraged bubble. It's the highly leveraged ones that really do the damage and the level of leverage makes them easier to spot. Consequently, I would worry less about asset values and focus on measures of leverage instead.

2009 Nov 18 07:48 AM

[John Bowman]

Powerless?...I believe the term is "clueless".

It's like they are playing a Monopoly game: "Aw shucks, that didn't work, let's try sumpin' else".

They have nothing to lose, they still keep their jobs. At the end of the day, they are shmoozin' with their rich buddies in glorious splendor while the economy crumbles.

2009 Nov 18 07:53 AM

[User 353732]

Vanity and a vast capacity for self delusion(and self aggrandizement) prevents the political Bosses WashDc or London or Tokyo from recognizing bubbles or properly deflating them once the bubble has become apparent to the few who can discern these things.

Vanity convinces the Bosses that they have profound and unique insights into economics, finance and the workings of markets and this insight allows them to control, manipulate and when necessary mutilate interconnected industries and complex economies into obeying the will of the Masters. In truth they have no impressive insights and much of that they "know" is false or incomplete.

Self delusion that leads the Bosses into believing that inflating asset values are an abiding vote in confidence in the ability of the Bosses to manufacture real performance and create genuine value.Very few inside a bubble can recognize one and when vanity and self delusion compound this inability to distinguish the fake from the genuine and lies from truth , then it is no surprise that the Bosses fail early and often.

Even when the Bosses do recognize there is a bubble it is in their manifest interest to not merely perpetuate it but inflate it further. As they are still doing.

2009 Nov 18 07:58 AM

[Harry Tuttle]

The Fed creates most of the bubbles.

2009 Nov 18 08:14 AM

[cash]

Blowing bubbles is way for the manipulators to bring suckers to the table. How else can they rake in millions & billions? Fed & treasury have powerful friends in this business and they call the shots.

2009 Nov 18 08:35 AM

[gabe borenstein]

In fact the FED did recognize the market "bubble" on the way in 1999,but the error was to address the issue via radically restrictive policy which had lead to dramatic market implosion.Untill mid of 2007 ,the FED once again had attempted to address the the issue of the market and the real estate bubble(they had called it inflation) by raising the FF to 5.5% from 1%.Unprecedented decompression was the result.Let's not forget Mr.Volcer under whose reign the FED had raised the FF to 20% . Major recession was the result . History shows that the FED in fact anticipates the "bubbles" but the applied monetary policy is invariably too aggressive.Evidently ,the FED in applying monetary brakes tends to forget the "monetary" lag and continues with restrictive policy for too long .
As for myself ,I had came to a conclusion that based on the past history ,when the FED is concerned about the "bubble" it will address the issue by derailing economy.
In 1999 I have met with portfolio manager for the Vatican ,Dr.Menginni .I have warned him about the market implosion ahead.
In September of 2007 ,in an interview with Brian Sullivan (Bloomberg TV) ,I had issued a warning about decompression ahead.
As of now ,I am impressed with the more dynamic approach that the FED has adopted ,although I do believe in the notion of too big to fail because of the psychological impact on the investment community.

2009 Nov 18 09:19 AM

[501327]

Central banks were created to be run by wise men who would try to steer the economy with prudent policies and have the sense to take punchbowl away when partygoers start getting inebrieted.

Instead, we have ended up with a council of blind men (buffoons might be a more apt description) who not only act irresponsibly but even appear to take immense pride in their cluelessness. Witness some of the recent pronouncements by the current and ex-Fed officials and they would seem to make Chuck Prince proud (about music playing and Citi dancing)

Bernanke (at NY Economists' forum) - "It is inherently extraordinarily difficult to know whether an asset's price is in line with its fundamental value" BUT then he went on to claim "It is not obvious to me in any case that there is any large misalignment currently in the US financial system". In response to a question on toxic assets that the FED has been buying, he was even more forth right and admitted "wished I knew the value of these assets".

Kohn - (effectively) FED could not have done a better job of managing medium term economic stability and if things did go wrong that was because bankers did not do their job (of self regulation), emerging markets chose to eat more agri-products and use more oil (thereby driving asset prices for commodities of all kinds).

Mishkin (FT op-ed article) - It is difficult to identify asset bubbles particularly for policy makers (who he claims are not that smart - "If they were smart why are they not rich"). He then goes on to make a case for "good" asset bubbles of the irrational variety which in his opinion tend to be relatively benign.

Yellen - ...not clear whether monetary policy should (bother to) lean against asset bubbles...because...it compromises with its other (higher) macroeconomic goals

With men (and women) like these in charge of economy, it is not a surprise that Goldman traders cheer every time one of these luminaries opens their mouth. And, Blankfein feels smug enough to go out and give sermonizing lectures about bankers' (read Goldman) doing God's work (and collecting their rightful pound of flesh).

2009 Nov 18 09:35 AM

[Alex Trias]

Very good point. The Fed shouldn't care if people want to lose their own money by overpaying for assets. Actually, it's probably important that the Fed make a point of staying out of the way to let the law of the market jungle separate fools from their capital and reward those with better investment thinking.

A leveraged bubble is another animal because it creates the potential for cascading failures, which punishes idiots and geniuses alike. Cascading failures such as what we saw in 2008 are not really the law of the jungle at play - more like a forest fire burning the jungle down to the ground and taking the fittest and the least fit down with it. There's nothing efficient about that.


On Nov 18 07:48 AM chap08 wrote:

> I partly agree with you, but I don't think that identifying (let
> alone bursting) bubbles is such an easy thing. If you think that
> the Fed should burst bubbles, then you have to be able to answer
> the following questions:
>
> 1. What is a bubble and what is the difference to over-valuation?
>
> 2. At what stage should the bubble be prevented or burst?
> 3. What is the relative priority of bursting bubbles and other economic
> objectives e.g. employment?
> 4. What assets should this be applied to e.g. healthcare stocks,
> sugar futures, Kansas housing, treasuries, gold?
> 5. Why should the Fed be better at spotting bubbles than the market?
> How would they determine if, say, stocks are in a bubble now, when
> for every hedgie that says they are, I can find one that says they're
> not?
>
> For my part, I see a big difference between a bubble and a highly
> leveraged bubble. It's the highly leveraged ones that really do the
> damage and the level of leverage makes them easier to spot. Consequently,
> I would worry less about asset values and focus on measures of leverage
> instead.

2009 Nov 18 09:49 AM

[ctjaeger]

Exactly. Leverage is the accellerant on the bursting bubble fire. History has taught us that asset bubbles form and subsequently break; it is a fairly simple study of human nature. However, when excessive leverage enters into the equation, recovery from the breaking of an asset bubble isn't so easy.

There were ample indicators of excessive leverage and of a coincidental series of asset bubbles. Rather than attempting to address the leverage issue, Greenspan claimed that nobody thought there was a bubble (it was just "froth") and, even if they did, it wasn't the job of the Fed to control those. Even if you agree with Greenspan, monetary policy has a direct impact on credit. Using monetary policy to address the imbalance in credit would have been both prudent and appropriate.

On Nov 18 07:48 AM chap08 wrote:

> I partly agree with you, but I don't think that identifying (let
> alone bursting) bubbles is such an easy thing. If you think that
> the Fed should burst bubbles, then you have to be able to answer
> the following questions:
>
> 1. What is a bubble and what is the difference to over-valuation?
>
> 2. At what stage should the bubble be prevented or burst?
> 3. What is the relative priority of bursting bubbles and other economic
> objectives e.g. employment?
> 4. What assets should this be applied to e.g. healthcare stocks,
> sugar futures, Kansas housing, treasuries, gold?
> 5. Why should the Fed be better at spotting bubbles than the market?
> How would they determine if, say, stocks are in a bubble now, when
> for every hedgie that says they are, I can find one that says they're
> not?
>
> For my part, I see a big difference between a bubble and a highly
> leveraged bubble. It's the highly leveraged ones that really do the
> damage and the level of leverage makes them easier to spot. Consequently,
> I would worry less about asset values and focus on measures of leverage
> instead.

2009 Nov 18 11:08 AM

[flow5]

gabe borenstein: Volcker did not pursue a "tight" monetary policy by any metric. Total reserves increased at a 18% annual rate of change coincident with the DIDMCA of March 31st 1980. Inflation killed itself (just as in hyperinflation). (the data was also killed by Anderson & Rasche's reconstruction).

MACRO MAN: Of course you can identify bubbles. It's mathematically impossible to miss economic projections (MVt=PT). MVt = bank debits, PT = nominal GDP.

I.e, the lag for nominal GDP varies widely, but the lags for both real growth & inflation are always exactly the same length.

2009 Nov 18 11:56 AM

[conceptwizard]

The CDO, MBS program cannot be stopped. Otherwise the big banks could never clear their balance sheets and the result would be bankruptcy. Thus, until those banks, brokerage houses and insurance companies are rid of their problem assets the program cannot end. If the program ends they all go under. The toxic assets being bought by the taxpayer via the Fed will have to be worked off over the next 30 years with grievous losses. The high sounding Supplementary Financing Program is a transference of debt from banks, Wall Street and insurance to the taxpayer. Even worse is the Fed’s ability to pay interest on the money banks have borrowed from them at a higher rate of course, allowing the taxpayer to give free money to the banks, which, of course, is insane.

2009 Nov 18 01:15 PM

[TheSnail]

"hell, even requiring mortgage applicants to send in $5.99 and two box-tops from Lucky Charms would significantly raise the reporting hurdle from its 2005 liar-loan nadir."


Dats a good one. But I owe my cavities to Captain Crunch and Quisp!!!

2009 Nov 18 02:55 PM