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How Can the Fed Prevent Asset Bubbles?

August 13, 2009

Tags Booms and BustsThe FedFinancial MarketsFree Markets

In his speech at the BIS conference in Basel, Switzerland, the president of the New York Federal Reserve, William Dudley, argued that asset bubbles pose a serious threat to real economic activity. He holds the view that the US central bank should develop effective tools to counter this menace. As things stand at present, said Dudley, a monetary policy that relies on short-term interest rates is not well-suited to deal with the emergence of bubbles.

According to Dudley, it should be the role of the Fed to stop the expansion of the bubble while it is still in the making. For instance, he argues:

Let's take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep "skin in the game," I think the housing bubble might not have been so big.

Hence, argues Dudley,

I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier.

Defining Bubbles

During his speech, the New York Fed chief executive never presented his definition of what a bubble is. We suspect that by bubble he means a very large — that is, strongly above the historical average — increase in asset prices. If we adopt this view, it would appear that the Fed has nothing to do with bubbles, and that (if anything) the US central bank is here to confront and eliminate this menace, which poses a threat to the well being of the US economy.

According to this way of thinking, the present economic crisis occurred on account of the bursting of a gigantic housing bubble, and were it not for Fed chairman Ben Bernanke, the outcome of the bust could have been catastrophic for the US economy.

We have seen that according to popular thinking, an asset bubble is a large increase in asset prices. A price is the amount of dollars paid for a given thing. We may just as well say, then, that a bubble is a large increase in the payment of dollars for various assets.

As a rule, in order for this to occur there must be an increase in the pool of dollars, or the pool of money. So, if one accepts the popular definition of what a bubble is, one must also concede that without an expansion in the pool of money, bubbles cannot emerge. If the pool of money is not expanding, then people — irrespective of their psychological disposition — simply do not have the ability to generate bubbles in various markets.

However, once the pool of money begins to expand, various individuals who have access to the new money can divert various assets to themselves by bidding asset prices higher. Furthermore, once the suppliers of goods observe that the prices of their goods are starting to go up, they begin to boost production. The increase in the production of goods is made possible by securing bank loans, which are expanded out of thin air — that is, through fractional reserve lending.

"How can massive monetary pumping and bottom-level interest rates possibly prevent an economic disaster?"

Note that credit out of thin air enables the borrowers to attain various resources by bidding their prices higher. This leaves fewer resources at the disposal of the genuine wealth generators.

Now, the key source in the expansion of the pool of money is the Fed's monetary pumping and commercial bank fractional-reserve lending. Of these two sources, the greater force is the monetary pumping of the central bank. Without the central bank creating new money, banks cannot expand credit out of thin air.

Note that an increase in the growth momentum of asset prices implies an increase in the growth momentum of the money supply. If, for whatever reason, the central bank slows down on the monetary pumping, this leads to a decline in the growth momentum of asset prices. Consequently, some market players are likely to start locking in their profits by selling assets.

Once more and more players begin trying to protect their profits, their actions quickly lead to a bursting of the asset bubble. Note that the trigger for the burst is actually the decline in the growth momentum of money supply. Again, as a rule the decline in the growth momentum of money supply is set in motion by a decline in the monetary pumping by the Fed.

So how can the central bank stop the emergence of asset bubbles? By not creating money out of thin air.

Examining the Evidence

Is it true, as Dudley maintains, that the Fed under Bernanke has prevented another economic depression in the United States? And what exactly did the Fed do to prevent the disaster?

Under the guidance of Ben Bernanke, the US central bank has lowered the federal funds rate from 5.25% in September 2007 to the current level of 0%. Since September of last year, the Fed has boosted the pace of money pumping through an aggressive expansion of its balance sheet. (The Fed has been buying assets and paying for this with money out of thin air).

As a result, the yearly rate of growth of Fed's balance sheet jumped from 3.9% in August 2008 to 152.8% by December of that same year. The size of the balance sheet climbed from $0.9 trillion in August 2008 to $2.1 trillion by April 2009.

In response to all of this pumping, the growth momentum of monetary measure AMS has accelerated. The yearly rate of growth jumped from 1.8% in August 2008 to 14.3% by June of this year.

  

The question that needs to be addressed is this: how can massive monetary pumping and bottom-level interest rates possibly prevent an economic disaster? Careful analysis shows that all these actions can do is to redistribute existing real savings — that is, real wealth — which is necessary to support economic activity.

All that aggressive Fed policies have actually achieved is weakening of the process of real wealth formation. This, in turn, has only weakened — and not strengthened — the economy's ability to grow. The only reason why the US economy didn't fall into a depression is because the pool of real savings is still holding its ground.

Conclusion

According to William Dudley, the US central bank should pay much closer attention to asset bubbles.

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The New York Fed chief holds the view that these bubbles pose a serious threat to real economic growth. He holds that, by means of its policy tools, the Fed can suppress bubbles in their early stages of emergence. He believes this to be an important factor in preventing unnecessary, deep recessions.

At no point in his speech did Mr. Dudley raise the possibility that the main source of asset bubbles could be the US central bank itself. We suggest that the best way to prevent the emergence of asset bubbles is to stop the Fed from pushing massive amounts of money to the economy.

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