An Essay I Wish I Had Written...
Alan Blinder:
Two Bubbles, Two Approaches for the Fed: LATELY more and more people have been questioning the received wisdom about what a central bank should do when confronted by an asset price bubble. That piece of wisdom, shared by Alan Greenspan and Ben S. Bernanke, the former and present Federal Reserve chairmen, holds that deliberate bubble-bursting is something between impossible and dangerous — and thus best avoided. Instead, according to this view, the Fed should let bubbles burst of their own accord, and then be prepared to mop up after.
This strategy has modest objectives... to limit collateral damage to the rest of the financial system, and especially to the overall economy. The Fed executed such a mop-up-after strategy with great success when the tech bubble popped spectacularly in 2000....
Those who now attack the Greenspan-Bernanke position make three main points: First, the strategy of letting bubbles die of natural causes, then mopping up, seems not to have worked so well this time around.... Second, critics contend that the mopping-up-after strategy sows the seeds of yet more bubbles... that the Fed’s superlow interest rates after the stock market bubble burst led us directly to the housing bubble. The Fed now stands accused of being a serial bubble blower. Third... that the Greenspan-Bernanke policy is inherently inflationary because of a built-in asymmetry....
In taking up these three arguments, it’s crucial to distinguish between... “bank-centered bubbles”... principally fueled by... crazy bank lending... other asset bubbles... [like the] tech-stock bubble....
I would argue that the central bank’s proper role is fundamentally different in the two types of bubbles.... When bubbles are not based on bank lending, the Fed has no comparative advantage over other observers in distinguishing between rising fundamentals and bubbly valuations.... I recall Mr. Greenspan thinking that he saw a stock market bubble as early as 1995, when Internet stocks barely existed and the Dow was under 5,000. Fortunately, he did not make the mistake of trying to burst it. Conversely, the tech bubble became obvious only in 1999 — by which time it was already enormous. That’s the first problem, and it’s a huge one. Here’s the second: Once a central bank correctly recognizes a bubble’s existence, what is it supposed to do? The Fed has no instruments aimed directly at, say, tech stocks, and practically no instruments aimed at stock prices more broadly....
But a bank-centered bubble is starkly different.... Whereas the Fed’s kit bag is pretty much empty when it comes to stock-market prices, it is stuffed full when it comes to taking aim at bank lending practices....
Finally, regarding inflation, let’s look at the record. The core inflation rate — that is, excluding food and energy prices — was in the 2 1/2 to to 3 percent range in 1995 to 1996, when serial bubble-blowing supposedly began. It has hovered in the 2 1/4 to 2 3/4 percent range in 2007 and so far in 2008. Do you see a rising trend?...
The Fed could have raised margin requirements on stocks in the 1990s, and served as national punchbowl-taker-away by speaking more and more gloomily about irrational exuberance. So it is not completely powerless: the bully pulpit is worth something. And the Fed's toolkit is not all that full when it comes to regulating non-bank banks--or has not been all that full: we very much hope this will change. But Alan Blinder definitely has his finger on it.
