Introduction
There is general agreement that the financial turmoil of 2007-2009 was caused by the bursting of the housing bubble, which triggered the worldwide economic crisis. Many scholars maintain that the crisis was instigated by the malpractice and miscalculation of private actors, a lack of regulation, and a bubble mentality (Moroni 1296). Therefore, there is no surprise that some commentators, when considering the relationship between the Federal Reserve and bubbles, argue for the Fed’s immediate intervention in inflating asset bubbles. The aim of this paper is to discuss whether the Fed’s policies should be used for the prevention of negative consequences of bubble bursts. The paper will also consider the pros and cons of the Fed’s regulation and argue that it is more reasonable to opt for the mitigation of damage from bubbles instead of trying to prevent their emergence.
Discussion
Identification
It is hard to deny that socio-economic phenomena cannot be attributed to a single cause; therefore, there is no surprise that it is extremely hard to identify bubbles. For example, when in 1996, Alan Greenspan spoke of ‘irrational exuberance,’ he wanted to warn investors that a bubble was forming (Kashkari). However, at the time of his speech, the P/E ratio of the S&P 500 was 17.8 (Kashkari). The stock market reached the P/E ratio of 26.9 in three years and saw a correction only in 2002 when the P/E ratio decreased to below 16 (Kashkari). Theories of bubbles are extremely complex and include a wide range of variables such as incentives of economic agents, media coverage, internal signals among traders, market structures, and neural mechanisms, among others (Smith et al. 10505).
The Fed’s Reaction
The Fed’s main policy instrument is the regulation of short-term interest rates (McDonald and Houston 439). By lowering interest rates when inflation does not exceed the Fed’s target limit, the central bank system tries to meet its dual mandate of increasing employment and achieving price stability. However, when inflation is high, the Fed uses its monetary policy to intervene in asset prices. Therefore, the main instrument that can be used by the Fed for the prevention of bubble formation is raising interest rates. However, by doing so, the Fed might negatively affect not only an industry in which a bubble is arising but also all capital-intensive industries, thereby harming the economy. It has to be borne in mind that in the period of the rapid increase in asset prices, it is extremely difficult to slow them down with moderate raising of interest rates.
Cost/Benefit Analysis
In terms of economic costs of the prevention of asset prices from rising further, the use of monetary policy might result in a recession. It means that in order to start using the instrument, the Fed must definitely know that a bubble is not a false positive. However, according to Brunnermeier and Schanbel, in order to spot a discrepancy between a value of an asset and its fundamental value, it is necessary to know its fundamental value (3). Given that the Fed’s monetary policy is an extremely blunt instrument, it can be argued that the costs of trying to prevent the inflation of a bubble outweigh the benefits of its buildup and subsequent burst.
Recommendations
In order to make the financial system more resilient to bubbles, it is important to ensure that the Fed is equipped with more precise instruments of asset market regulation than simply raising interest rates. For example, in addition to limiting the amount of debt for buying stocks, the Fed should be able to regulate the loan-to-value requirements of mortgages issued by banks (Kashkari). By doing so, the central banking system will be able to directly burst a housing bubble without negatively affecting other sectors of the economy.
There is ample evidence suggesting that the reduction of the federal funds rate that started in 2001 fueled the growth of the housing bubble (Moroni 1301). The Fed’s manipulation of the interest rate resulted in an unprecedented 1 percent rate in 2003 (Moroni 1301). Gjerstad and Smith argue that if it were not for expansionary monetary policy, the 2001 recession would have stopped the inflation of the bubble (qtd. in Moroni 1301). Furthermore, McDonald and Houston (450) posit that the sharp rate increase in the period from 2004 to 2006 resulted in the decline of housing prices. Therefore, instead of engaging in the prevention of the emergence of bubbles, which might be extremely costly for the economy, the Fed has to concentrate more on the mitigation of damage from already existing bubbles and on making sure that the country’s financial institutions are sound.
If the Fed manages to identify an overvalued class of assets, it should calculate how a bank’s solvency would be affected by a fall in asset prices under the conditions of a weak economy (Kashkari). Banks that do not have enough financial wherewithal to withstand losses should be subjected to reductions in their share buybacks, which will help them to accumulate the capital needed for a correction (Kashkari). Also, it is necessary to abolish the policies aimed at the promotion of homeownership that provides tax breaks to the housing industry, thereby stimulating the emergence of bubbles.
Conclusion
The paper has helped to better understand the Fed’s role in deflating bubbles that can have a devastating effect on the country’s economy. It has been argued that instead of concentrating on the prevention of bubble inflation, the Fed should exert its efforts toward the mitigation of their effects.
Works Cited
Brunnermeier, Markus, and Isabel Schanbel. “Bubbles and Central Banks: Historical Perspectives.” Scholar, Web.
Kashkari, Neel. “Monetary Policy and Bubbles.” Minneapolisfed, Web.
McDonald, John, and Stokes Houston. “Monetary Policy and the Housing Bubble.” Journal of Real Estate and Financial Economy, vol. 46, no. 1, 2013, pp. 437-451.
Moroni, Stefano. “Interventionist Responsibilities for the Emergence of the US Housing Bubble and the Economic Crisis: ‘Neoliberal Deregulation’ is Not the Issue. European Planning Studies, vol. 24, no. 7, 2016, pp. 1295-1312.
Smith, Alec, et al. “Irrational Exuberance and Neural Crash Warning Signals During Endogenous Experimental Market Bubbles.” PNAS, vol. 111, no. 29, 2013, pp. 10503-10508.