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In his speech at
the BIS conference in Basel, Switzerland, the president of the New York
Federal Reserve, William Dudley, argued that asset bubbles pose a serious
threat to real economic activity. He holds the view that the US central bank
should develop effective tools to counter this menace. As things stand at
present, said Dudley, a monetary policy that relies on short-term interest
rates is not well-suited to deal with the emergence of bubbles.
According to
Dudley, it should be the role of the Fed to stop the expansion of the bubble
while it is still in the making. For instance, he argues:
Let's take the
housing bubble as an example. Housing prices rose far faster than income. As
a result, underwriting standards deteriorated. If regulators had forced
mortgage originators to tighten up their standards or had forced the
originators and securities issuers to keep "skin in the game," I
think the housing bubble might not have been so big.
Hence, argues
Dudley,
I think that this
crisis has demonstrated that the cost of waiting to clean up asset bubbles
after they burst can be very high. That suggests we should explore how to
respond earlier.
Defining Bubbles
During his
speech, the New York Fed chief executive never presented his definition of
what a bubble is. We suspect that by bubble he means a very large
— that is, strongly above the historical average — increase in
asset prices. If we adopt this view, it would appear that the Fed has nothing
to do with bubbles, and that (if anything) the US central bank is here to
confront and eliminate this menace, which poses a threat to the well being of
the US economy.
According to this
way of thinking, the present economic crisis occurred on account of the
bursting of a gigantic housing bubble, and were it not for Fed chairman Ben
Bernanke, the outcome of the bust could have been catastrophic for the US
economy.
We have seen that
according to popular thinking, an asset bubble is a large increase in asset
prices. A price is the amount of dollars paid for a given thing. We
may just as well say, then, that a bubble is a large increase in the payment
of dollars for various assets.
As a rule, in
order for this to occur there must be an increase in the pool of dollars, or
the pool of money. So, if one accepts the popular definition of what a bubble
is, one must also concede that without an expansion in the pool of money,
bubbles cannot emerge. If the pool of money is not expanding, then people
— irrespective of their psychological disposition — simply do not
have the ability to generate bubbles in various markets.
However, once the
pool of money begins to expand, various individuals who have access to the
new money can divert various assets to themselves by bidding asset prices
higher. Furthermore, once the suppliers of goods observe that the prices of
their goods are starting to go up, they begin to boost production. The
increase in the production of goods is made possible by securing bank loans,
which are expanded out of thin air — that is, through fractional
reserve lending.
"How can
massive monetary pumping and bottom-level interest rates possibly prevent an
economic disaster?"
Note that credit
out of thin air enables the borrowers to attain various resources by bidding
their prices higher. This leaves fewer resources at the disposal of the
genuine wealth generators.
Now, the key
source in the expansion of the pool of money is the Fed's monetary pumping
and commercial bank fractional-reserve lending. Of these two sources, the
greater force is the monetary pumping of the central bank. Without the
central bank creating new money, banks cannot expand credit out of thin air.
Note that an
increase in the growth momentum of asset prices implies an increase in the
growth momentum of the money supply. If, for whatever reason, the central
bank slows down on the monetary pumping, this leads to a decline in the
growth momentum of asset prices. Consequently, some market players are likely
to start locking in their profits by selling assets.
Once more and
more players begin trying to protect their profits, their actions quickly lead
to a bursting of the asset bubble. Note that the trigger for the burst is
actually the decline in the growth momentum of money supply. Again, as a rule
the decline in the growth momentum of money supply is set in motion by a
decline in the monetary pumping by the Fed.
So how can the
central bank stop the emergence of asset bubbles? By not creating money out
of thin air.
Examining the
Evidence
Is it true, as
Dudley maintains, that the Fed under Bernanke has prevented another economic
depression in the United States? And what exactly did the Fed do to prevent
the disaster?
Under the
guidance of Ben Bernanke, the US central bank has lowered the federal funds
rate from 5.25% in September 2007 to the current level of 0%. Since September
of last year, the Fed has boosted the pace of money pumping through an
aggressive expansion of its balance sheet. (The Fed has been buying assets
and paying for this with money out of thin air).
As a result, the
yearly rate of growth of Fed's balance sheet jumped from 3.9% in August 2008
to 152.8% by December of that same year. The size of the balance sheet
climbed from $0.9 trillion in August 2008 to $2.1 trillion by April 2009.
In response to
all of this pumping, the growth momentum of monetary measure AMS has
accelerated. The yearly rate of growth jumped from 1.8% in August 2008 to
14.3% by June of this year.
 
The question that
needs to be addressed is this: how can massive monetary pumping and
bottom-level interest rates possibly prevent an economic disaster? Careful
analysis shows that all these actions can do is to redistribute existing real
savings — that is, real wealth — which is necessary to support
economic activity.
All that
aggressive Fed policies have actually achieved is weakening of the process of
real wealth formation. This, in turn, has only weakened — and not
strengthened — the economy's ability to grow. The only reason why the
US economy didn't fall into a depression is because the pool of real savings
is still holding its ground.
Conclusion
According to
William Dudley, the US central bank should pay much closer attention to asset
bubbles.
The New York Fed
chief holds the view that these bubbles pose a serious threat to real
economic growth. He holds that, by means of its policy tools, the Fed can
suppress bubbles in their early stages of emergence. He believes this to be an
important factor in preventing unnecessary, deep recessions.
At no point in
his speech did Mr. Dudley raise the possibility that the main source of asset
bubbles could be the US central bank itself. We suggest that the best way to
prevent the emergence of asset bubbles is to stop the Fed from pushing
massive amounts of money to the economy.
Frank Shostak
Frank Shostak is a former professor of
economics and M. F. Global's chief
economist.
Also
by Frank Shostak
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