The roots of "cleaning up after bubbles"

This item at The Economists' Free Exchange blog not only provides a link to an interesting 2004 speech by Fed Chairman Ben Bernanke titled Money, Gold and the Great Depression (excerpted directly below), but it also offers a few thoughts about "cleaning up after bubbles".

Friedman and Schwartz emphasized at least four major errors by U.S. monetary policymakers. The Fed's first grave mistake, in their view, was the tightening of monetary policy that began in the spring of 1928 and continued until the stock market crash of October 1929 ... The economy was only just emerging from a recession, commodity prices were declining sharply, and there was little hint of inflation. Why then did the Federal Reserve raise interest rates in 1928? The principal reason was the Fed's ongoing concern about speculation on Wall Street. Fed policymakers drew a sharp distinction between "productive" (that is, good) and "speculative" (bad) uses of credit, and they were concerned that bank lending to brokers and investors was fueling a speculative wave in the stock market. When the Fed's attempts to persuade banks not to lend for speculative purposes proved ineffective, Fed officials decided to dissuade lending directly by raising the policy interest rate.

The market crash of October 1929 showed, if anyone doubted it, that a concerted effort by the Fed can bring down stock prices. But the cost of this "victory" was very high. According to Friedman and Schwartz, the Fed's tight-money policies led to the onset of a recession in August 1929, according to the official dating by the National Bureau of Economic Research. The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October. In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it.

This topic is getting a lot attention at the Federal Reserve gathering in Jackson Hole this weekend where at least one paper argues that the central bank can not be "timid" when interest rates are raised and other aid to the economy is withdrawn.

Of course, that's much easier said than done.

Everyone can now look back at the last interest rate raising cycle that ran from 2004 to 2006 and conclude that rates were left too low for too long. It is on this subject of "cleaning up after bubbles" that a few thoughts are offered:

Alan Greenspan got a lot of credit for the way he handled the tech bubble a decade ago, which essentially involved letting the bubble pop on its own and then cleaning up the mess. This strategy has since received quite a bit of criticism, given that the clean-up operation (very low interest rates for an extended period of time) contributed to inflation of a housing bubble, the popping of which caused an enormous amount of damage. An effort to attack the housing bubble earlier might have reduced the severity of the current recession. (Others have argued that debt and equity bubbles require different treatments.)

On the other hand, the Fed wasn't exactly standing pat during the growth of the housing bubble. From June of 2004 until June of 2006, the Fed steadily raised interest rates. Housing prices began falling around May of 2006. At the time of the rate increases output was posting some nice gains, but prices weren't rising by all that much. It's very interesting to think about how the period from 2006 until now might have been different if in 2004 and 2005 the Fed had taken a strong rhetorical and regulatory stance against the housing bubble but had kept rates at relatively low levels.

So far, everyone seems OK with the idea that we can inflate another stock market bubble to take the place of the burst housing bubble that followed the burst internet stock bubble.

In fact, as far as I can tell, people are embracing that idea, particularly in China.

Whatever it is that gets inflated, rest assured that it will not reach true bubble proportions until at least a year or two after rates begin to rise. As seen in 1928, 1999, and 2004, rising rates have a way of emboldening financial market bubbles for some time, that is, up until the point that higher interest rates contribute to their popping.

Here's a chart that helps make that point: