What should the Federal Reserve do—and what can the Federal Reserve do—about investment bubbles? On Friday, the Wall Street Journal profiled a group of Princeton economists who have been hired by current Federal Reserve Chairman Ben Bernanke to study the subject. "The Princeton squad argues that the Fed can and should try to restrain bubbles," the Journal wrote, "rather than following former Chairman Alan Greenspan's approach: watchful waiting while prices rise and then cleaning up the mess after a bubble bursts."In a speech on the same topic last Thursday, Federal Reserve Gov. Frederic Mishkin said that while the Fed probably shouldn't be in the asset-bubble-bursting business, it should have mechanisms in place to stop periodic outbursts of investor insanity from infecting the credit system.
Interesting stuff. But history has shown that the Fed doesn't possess the right tools, the right mentality, or the right personnel to consistently stave off bubbles. Over the decades, we've seen bubbles come and go—telegraph companies and railroad stocks in the 19th century; stocks and consumer credit in the 1920s; dot-com/telecommunications in the 1990s; and real estate and a proto-bubble in alternative energy in this decade. All have created significant damage, and almost all have left significant good behind, as I've argued. (I won't sink to the self-promoting depths of boring you with the argument of my book, Pop! Why Bubbles Are Great for the Economy, which is now available in Chinese and German.) Bubbles happened when the United States didn't have a central bank (the 19th century), when the Fed was an immature institution still getting its legs under it (the 1920s), and when it was at the height of its powers and public esteem (the Greenspan years).
So how could the Fed stop bubbles? One way might be for Federal Reserve chairs and other officials to use their credibility to talk down investors from making poor bets. But even on its best days, the market doesn't listen to reason. During a bubble? Forget about it. A bespectacled jargon-dispensing economist standing astride the rails and yelling stop isn't likely to have much effect on a runaway locomotive. Alan Greenspan gave his famed irrational exuberance speech on Dec. 5, 1996. But the Dow Jones Industrial Average and the NASDAQ ran up 82 percent and 288 percent, respectively, in the three years after the speech—before popping.
Rather than talk, the Fed could act by raising interest rates to choke off speculation. This might be a useful tool if the bubble is primarily in credit—jacking up the Federal Funds rate from its 2004 low of 1 percent more quickly would certainly have forestalled the worst of the recent housing speculation—or if the bubble is being held aloft in part by stocks that speculators bought on margin, as was the case in the late 1920s. But when the bubble is in assets like railroad bonds or in telecommunications stocks, which people are buying in their cash accounts, or in ethanol plants, the Fed's ability to control short-term interest rates won't help much. Raising rates to the point at which it would choke off speculation in an isolated area would have a harsh effect on the nonbubbly economy. Imagine chemotherapy in which a powerful toxin would destroy the cancer but also destroy lots of healthy tissue in the process.
While an independent agency, the Federal Reserve is a part of the U.S. government. And far from combating bubbles, government agencies through the years have helped start, perpetuate, and prolong them. When an industry becomes a juggernaut (dot-com, real estate, alternative energy), the momentum in Washington always weighs in favor of helping the bubbled interest with more subsidies, more tax credits, more cheap money. At times, the bubble sectors can hijack government policy. In February 1929, Charles Mitchell, the CEO of National City bank and a governor of the New York Federal Reserve, helped put the kibosh on the New York Fed's efforts to cut off speculative lending on stocks by raising interest rates. As the Fed considered raising rates, William Crapo Durant, the founder of General Motors, bought airtime on CBS radio and proclaimed: "Let the Federal Reserve Board keep its hands off business." Today, even as there are signs of a bubble in alternative energy, some of the venture capital money plowed into the sector is deployed to lobby for more government support.
Washington policymakers are generally eager to help prolong the bubble sectors because they become significant engines of growth. Asha Bangalore of Northern Trust found that between November 2001 and October 2005, housing and real estate accounted for 36 percent of U.S. private-sector payroll job growth. Advocating policies to deflate bubbles would be like the coaches tripping up running backs as they're sprinting for the end zone. At a time when private sector money is flowing into cleantech at record pace, the only thing the three remaining presidential candidates can agree on is the need for the government to invest in green-collar jobs to revive the economy, ensure national security, and clean up the environment. There's not much the Fed could do to slow this biodiesel-powered train.
Finally, the Federal Reserve is an organization much like any other—run by human beings with fallible judgment, driven by consensus, and less than congenial for contrarians. In bubbles, skeptics are always marginalized while the promoters are anointed as seers.And when a bubble gets loose, it infects every institution: banks, the media, and, yes, the Federal Reserve. The Fed, in the person of Alan Greenspan, failed to diagnose the Internet bubble accurately, and it misjudged the housing bubble, too. The Fed, in the person of Ben Bernanke, failed to see the credit mess coming. And once that crisis hit, the Fed failed to accurately gauge its scope and depth. When the party really gets going, we all drink from the same punch bowl.