Central Bankers to Pop Asset Bubbles

Bloomberg reports on the annual central banker symposium taking place at Jackson Hole, Wyoming. At last year's event, Greenspan defended his long-held view that central bankers cannot identify asset bubbles until after they have burst. This is based on a sort of "efficient markets theory" in which the prices of financial assets are an outcome of the informed judgement of a large number of economic agents, and that central bankers are not in a position to second-guess market prices. Additionally, the best policy for central bankers, in the Chairman's view, is to try to clean up the mess after the bubble pops. This policy was carried out as Greenspan cut interest rates to near zero after the 2000 stock market bust.

At this year's event, we read that opinion of central bankers is shifting toward a more activist role in slowing down bubbles before they get out of control. A great deal of the damage done by a bubble, it is believed, could be avoided if the central bank were to prudently poke it with a sharp needle before it became unreasonably large.

But what causes bubbles? In the Bloomberg report, the bankers quoted believe that bubbles are another example of market failure.

``Who are we to say a person's decision to buy a house is right or wrong?'' said Hung Tran, deputy director at the International Monetary Fund in Washington. Central banks should make sure financial institutions are strong and lending prudently. ``That is more relevant.''

Nowhere is the role of central banks in creating bubbles questioned. Mr. Tran should explain how the individual has obtained the funds to purchase the home. Most likely the home was purchased on credit that was created out of nothing through a fractional reserve bank, whose assets are leveraged on top of its account with the Fed. The credit was probably packaged into a security by Fannie Mae and sold to a foreign central bank, with an implied guarantee provided by the Fed.

Instead, this "new thinking" by central bankers -- that the cost of popping nascent bubbles is less than the cost of inflating the rubble the remains when they burst -- is presented as a superior form of monetary central planning. Bubbles "just happen", and central bankers, now that they are more experienced in dealing with them, will make the wise choice.

Robert Blumen

Robert Blumen is an independent software developer based in San Francisco, California