KPCC Radio: Federal Reserve
What Planet Does He Live on? Robert Lucas on Mortgages and Monetary Policy

What Should Have Been Done? Worldwide Bubble Trouble

Robert Shiller writes about worldwide bubble trouble. In Shiller's view, Alan Greenspan is broadly right in his belief that the Federal Reserve could not have popped the housing bubble without inflicting unacceptable collateral damage on employment and production:

The boom, and the widespread conviction that home prices could only go higher, led to a weakening of lending standards... [and] a number of financial innovations... all would be well, the reasoning went, on the premise that home prices continue to rise at a healthy pace.

At the Jackson Hole conference, Paul McCulley of PIMCO... argued that in the past month or two we have been witnessing a run on what he calls the "shadow banking system"... the levered investment conduits.... Bank runs occur when people, worried that their deposits will not be honored, hastily withdraw their money, thereby creating the very bankruptcy that they feared. It is no coincidence that this new kind of bank run originated in the U.S., which is the clearest example of falling home prices in the world today....

The U.S. Federal Reserve is sometimes blamed for the current mortgage crisis, because excessively loose monetary policy allegedly fueled the price boom that preceded it. Indeed, the real (inflation-corrected) federal funds rate was negative for 31 months, from October 2002 to April 2005.... But loose monetary policy is not the whole story. The unusually low real funds rate came after the U.S. housing boom was already well under way.... Alan Greenspan, the former Fed chairman, recently said that he now believes that speculative bubbles are important driving forces in our economy, but that, at the same time, the world's monetary authorities cannot control bubbles. He is mostly right: the best thing that monetary authorities could have done, given their other priorities and concerns, is to lean against the real estate bubble, not stop it from inflating.

The current decline in home prices is associated just as clearly with waning speculative enthusiasm among investors, which is likewise largely unrelated to monetary policy. The world's monetary authorities will have trouble stopping this decline, and much of the attendant problems, just as they would have had trouble stopping the ascent that preceded it...