Bubble dilema for central banks

Morgan Stanley's Richard Berner reports on the ongoing debates in the Fed's annual Jackson Hole powwow. My heat-impaired self hasn't gotten around to reading all the speeches, but Berner does touch a very important point: should central banks preemptively try to prevent bubbles from appearing?

Historically, the Federal Reserve has taken the hands-off approach, just standing by to clean up the mess once bubbles burst. Fed governor Frederic Mishkin has been an outspoken defender of this asymmetric intervention policy.

Yet, as the current and previous episodes illustrate, "cleaning up" is easier said than done. One mistake and you're into "Japanese lost decade" territory. Hence, some European central bankers have come around to the intervene-early camp.

There are no easy answers, but this is a crucial debate. Let us hope it doesn't fade away as it did after the last bubble was cleaned up (sowing the seeds of the current one).

In defense of bubbles

The chic contrarian position nowadays is to argue that financial bubbles do have benefits. First, Daniel Gross defended the tech bubble (it was not only good, it was great!) as a means to encourage lots and lots of investment and innovation which provide long-term gains to society. Hardly a scientific argument, but it does make some sense.

Now, on these grounds it is much harder to defend the real estate bubble. Yes, there was some financial innovation involved, as Gross mentions. But it certainly was not of the life-changing variety (as were the Internet or railroads) and it was mostly already in place before the party got underway.

So did it provide benefits? Mystery blogger Knzn argues that it was the only way to ensure that a recovery took hold after the 2001 recession.

He's right, to an extent. The purpose of lowering rates to 1% was to get people to spend (the government could only do so much and firms were hungover). In a very anemic job growth environment, such as the one from 2002-2005, the only way to do that was through asset reflation, mainly residential real estate.

The real problem was that rates stayed too low for too long. In 2004 and 2005, a period in which the recovery had evidently taken hold, house prices (measured by the Case-Shiller composite index) rose 18.7% and 15.9%, respectively. And it was in 2005 and 2006 when subprime mortgage originations rocketed. If the Fed and other financial regulators had acted sooner, things woldn't have gotten out of hand to the degree that they did.

Sure, there's a fine line between asset reflation and a bubble. But it is clear that real estate bubbles are much more dangerous (they affect most people) and have a much more negative effects (depleted savings, high debt, excessive investment in nonproductive assets, screwing future hombe buyers, etc.) than garden variety stock market bubbles, with no long-term upside.