For many years the Greenspan orthodoxy at the Fed was that central banks should not attempt to prick asset bubbles but instead stand ready to clean up the mess when markets did their job.  Fed staff and reserve bank presidents dutifully repeated that mantra.  But after Greenspan’s departure, governors (or former governors) such as Rick Mishkin and current reserve bank presidents like Janet Yellen (Federal Reserve Bank of San Francisco) and, most recently, Bill Dudley (Federal Reserve Bank of New York) have not only raised the issue but have suggested that perhaps central banks should intervene.  In a June speech in Basel Switzerland, President Dudley succinctly summarized the issues when he noted that the concerns of those who argue that “pricing bubbles is too hard” rest on three propositions: that bubbles are to hard to identify as they are emerging, that the current tools of monetary policy are too blunt to deal with asset price bubbles, and therefore, that the costs of attempting to deal with bubbles outweigh the benefits.  Put another way, there simply are too many false positives.

President Dudley took a different stand on the issue, however, concluding that the most recent real estate bubble wasn’t that hard to identify and that if central banks lack the surgical tools necessary to deal with a bubble, then they should seek and be given the necessary tools.  While this may make a good speech, let us consider the practical realities of attempting to implement such a policy.   

Pricking bubbles requires early identification, the appropriate level of timely intervention, and the proper tools to dampen the bubble without causing a market collapse or having broad negative spillovers to other markets.   The Fed’s main tools of targeting the Federal Funds rate, adjusting reserve requirements, and changing the discount rate are not suited to targeting bubbles in specific financial, product, or geographic markets.  Furthermore, what criteria should be employed to decide when a bubble is significant enough to warrant intervention from a macro policy perspective?   Should we worry, for example, about a run-up in the prices of oil or gold?  Gold and oil, like other commodities, are favorite bellwethers for many commentators concerned about inflation, yet the prices of both are determined in international markets over which the US has no authority, nor do we have the tools to dampen a run-up in gold or oil  prices. 

So do we confine the asset price focus to only domestic prices and local US markets?  If so, what are those markets?  Because asset price bubbles, at least in housing, start at the local level and don’t explode all at once into a nationwide problem, how broad must an asset price bubble be before it qualifies for government intervention?  Finally, consider how financial markets would respond to the knowledge that the government would intervene every time a market might be getting overheated.  Short sellers and speculators would step in big time; but of course, we are currently pursuing efforts to curtail short selling as well.

As President Dudley’s speech suggests, the favorite market for discussion right now is the US housing market.  It is essentially local to the US and it is a real asset market, but there are significant links to financial markets that we can all agree upon.  President Dudley notes, as evidence that bubbles may not be that hard to identify, that some commentators had identified the housing bubble as early as 2005. 

But let us look briefly at some of the facts.  Housing sales began to decline as did new permits and construction in mid-2005.  Furthermore, the Fed had embarked upon a long series of Fed Funds rate increases beginning in the fall of 2004 that peaked in 2006 at 5.25%, 425 basis points above where the target rate was in the fall of 2003.  What more should have been done, given what appeared to be happening to the supply of existing and new houses, and what tools should the Fed have identified and sought as additional powers from Congress to deal with the housing price problem?  Without putting flesh on the simplistic stand that someone should have done something, we are left with a non-policy policy. 

Consider, for example, the reception the Fed would likely have gotten had it gone to Congress in 2005 and asked for powers to essentially shut down the US housing market.  Keep in mind that this would have been after Clinton administration initiatives put in place in 1999 to increase mortgage lending to low-income and minority areas and to increase the proportion of such lending on the books of Freddie and Fannie.  Furthermore, Congressman Barney Frank made the following remarks on June 27, 2005 on the floor of the US House of Representatives:

"Those who argue that housing prices are now at a point of a bubble seem to me to be missing a very important point. Unlike previous examples we have had when substantial excessive inflation of prices later caused problems we are talking here about an entity, home ownership, homes where there is not the degree of leverage where we have seen elsewhere. This is not the dot-com situation. We had problems with people having invested in business plans of which there was no reality; people building fiber optic cables for which there was no need. Homes that are occupied may see an ebb and flow in the price at a certain percentage level. But you're not going to see the collapse that you see when people talk about a bubble and so those of us on our committee in particular will continue to push for home ownership."

That view from a member of the committee that would have a significant say on what powers the Fed might be granted doesn’t signal strong bipartisan support for shutting down the housing market.

So far we are talking about a problem that with hindsight appears more clear to some, relative to the problems that have not yet emerged.  But even that event doesn’t suggest what should have been done nor when nor by whom.  Without a clear set of guidelines as to which markets are to be considered candidates for concern about bubbles – be they real or financial markets – and without a designated agency or agencies charged with monitoring those markets and the necessary powers to intervene when they start to overheat, it appears arguable that Chairman Greenspan’s approach, together with a responsible monetary and fiscal policy may be the most that can be done consistent with the efficient functioning of free markets.