The impossibility of defusing nascent asset bubbles

After two asset bubbles of gargantuan proportions have inflated and popped in less than a decade, a dim incandescent glow is starting to appear inside the heads of the nation's sharpest dismal thinkers.

In a speech yesterday at the European Economics and Financial Centre in London, Minneapolis Federal Reserve Bank President Gary Stern wondered aloud if the policies of former Fed chairman Alan Greenspan might not have been such a good idea.

Recall that, over the last ten years, monetary policy in the U.S. permitted (some would say, encouraged) huge stock market and real estate market bubbles, both of which met their inevitable pin with deleterious consequences for the economy as a whole.

This Bloomberg report has all the details:

Federal Reserve officials may be rethinking their aversion to acting against asset-price bubbles, an article of faith during former Chairman Alan Greenspan's 18 years at the helm.

After this month's near-collapse of Bear Stearns Cos., Minneapolis Fed Bank President Gary Stern -- the longest-serving policy maker -- said in a speech yesterday that it's possible "to build support" for practices "designed to prevent excesses."
...
Fed officials have spent years wrestling with how to prevent bubbles without damaging the economy through high interest rates, and few have come up with an answer. That's partly because the debate focused on use of the main policy rate instead of regulatory tools.

For two decades, the ruling philosophy has been Greenspan's. "It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization," Greenspan told the American Economic Association in 2004.

"I have always said if we could defuse a nascent asset bubble, I would be all for it," Greenspan, 82, said in an e- mailed response to a question yesterday. "The reason I am against is that in my experience it cannot be done. I know of no occasion when such actions have been successful."
...
Stern has spoken publicly only seven times in the last year. The Minneapolis president co-authored a 2004 book called "Too Big to Fail: the Hazards of Bank Bailouts,'' which concluded that while governments shouldn't avoid public support for creditors of failing banks, they should minimize that backing because of the distortions it produces.

"If someone like that, steeped in the Fed's traditions, opens the door to a new or different approach to policy, we have to take it seriously," said Robert McTeer, a former president of the Dallas Fed.

After all the criticism directed toward the Federal Reserve now that it is painfully clear that the mid-decade economic recovery was just another asset bubble that has since met its pin, self-preservation may prove to be a very powerful motivational force for change at the U.S. central bank, now closing in on its 100-year anniversary in a few years.