Bubble-Boom and the Necessary Role of Central Banking
In a perceptive comment on yesterday’s Daily, “Bernanke’s Legacy: A Weak and Mediocre Economy”, mkm writes:
Whilst the Fed and Bernanke had a role in the 2008 financial collapse, we should not forget the other actors who were probably more culpable than them. They will include the social pressure groups who pushed for the 70% house ownership policy; the politicians who supported it for electoral reasons; the credit institutions who encouraged and stoked it for person gain; the Government and Legislative institutions who failed in their duty to control it; and the accounting/legal authorities who failed to have in place mechanisms/accounting rules and practices appropriate to control the malfeasance which has been well documented in the past. This is not just a matter for economists.
However, without central bank actions or other special privileges for fractional reserve banks which allow sustained credit creation, bubbles are relatively self-contained with most damage limited to those who make bad ‘investment‘ decisions.
Roger Garrison, as he often is, is right on in his analysis of the relative role of the mortgage-housing specific aspects of the recent crisis and the role of the Fed. From his Alchemy Leveraged: The Federal Reserve and Modern Finance:
Unsound as these policies were, they were not the principal cause of the financial crisis. Again, Dowd and Hutchinson are right in identifying the expansion-prone Federal Reserve as the principal institutional cause. Had the Fed provided no fuel for the boom, federal housing policy, though perverse, would not have been unsustainable. The mortgage market would have had to compete with all other markets for the funds that savers provided. There would have been a continuing bias in favor of the mortgage market, and the ongoing rate of foreclosures would have been higher. House prices would have been higher (because houses and mortgage loans are complements), but they would not have been high and rising. Practitioners of modern finance would have paid due attention to the higher VaR, which would have reflected the expectation of an ongoing higher foreclosure rate. Conversely, had the federal government not enacted legislation and created institutions that rigged mortgage markets so as to increase home ownership, credit expansion by the Fed would nonetheless have created an artificial boom, which inevitably would have ended in a bust.
Although Fannie, Freddie, and related federal legislation are not the principal cause of the crisis, they do account for the particular character of the preceding boom and hence for the particular character of the subsequent bust. The terms boom and bubble are often used interchangeably in the literature on business cycles. It may be preferable, however, to use boom—or more specifically artificial boom—to refer to the credit-induced simultaneous expansion to various degrees of different interestsensitive sectors of the economy and to use bubble to refer to the artificial boom’s most dramatic manifestation. Which sector reveals itself as the bubble depends on the circumstances in which the credit expansion occurs. As indicated earlier, artificial booms entail a turbocharging of whatever else is going on at the time.
Again the best solution to boom-bust is prevention, not clean-up after the fact, which no matter what action or non-action (see Pierre Lemieux’s Somebody in Charge: A Solution to Recessions?) is chosen involves unnecessary painful readjustment. In general, market -based (non-action) are in the long run less painful.