A Limited Understanding

The more Federal Reserve speeches you read, the more you wonder how our bubble economy will ultimately fare amid a growing sea of pins. Case in point - Donald L. Kohn speaking yesterday in Germany on the relationship between monetary policy and asset bubbles.

The mainstream media fixation on Mr. Kohn's words centered on the subject at the top of every economist's list of concerns for 2006 - how a softening (or worse) of the housing market will affect the overall economy and what the monetary policy response will be.

Since the response to the bursting of the stock market bubble in 2000 resulted in the inflation of another asset class in housing, this is a natural question to ask. There seems to be a pattern developing - serial bubbles, as Stephen Roach calls them.

The answer? According to Mr. Kohn, the Federal Reserve will not act to protect housing prices should they falter:

... if real estate prices begin to erode, homeowners should not expect to see all the gains of recent years preserved by monetary policy actions. Our actions will continue to be keyed to macroeconomic stability, not the stability of asset prices themselves.

That sounds a little scary, but homeowners shouldn't be too alarmed (except of course for recent first-time buyers). The Fed will not attempt to preserve all the gains of recent years, but heaven and earth will be moved to preserve most of them.

There really is no alternative.

Given that macroeconomic stability is based, as never before, on lofty housing prices which enable borrowing and spending in the U.S., which in turn drives the world economy, under what scenario would a significant drop in real estate values not result in instability?

Seriously.

Like we're going to create hundreds of thousands of alternative energy jobs to replace the ones lost in mortgage finance and home improvement, and then everyone will learn to live within their means?

Even more striking when it comes to how the Fed views the relationship between asset prices and monetary policy are the following excerpts, which, when spliced together as below, paint a picture of either willful neglect or extreme denial:

Practically speaking, however, I view our ability to act on such suspicions [of the existence of bubbles] as limited given how little we know about the dynamics of speculative episodes.
...
Finally, I think it fair to say that most central banks, faced with only a limited understanding of asset prices and their interactions with the full economy, engage in a form of risk management when dealing with market booms and busts.
...
In general, we have a very poor understanding of the forces driving speculative bubbles and the role played by monetary policy.
...
More broadly, further research into the causal connections, if any, between monetary policy and bubbles would seem to be needed before we would know enough to be able to act on such linkages with much confidence.

That's a hefty lack of understanding about what today, more than anything else, drives the world economy. It's almost as if the U.S. Fed is not interested - as if they just don't want to know what 18 years of Alan Greenspan has wrought.