Tuesday, August 25, 2009

Bernanke and Popping Bubbles

Stephen Crowley/The New York Times

The New York Times, reports that President Obama is keeping Ben Bernanke on for a second term as Chairman of the Federal Reserve. This is very good news. Bernanke has responded to the crisis forcefully, creatively and decisively and I have no doubt that his quick actions prevented a much worse economic crisis.

Some, like this post at Calculated Risk, are criticizing him, saying that he was late to recognize the housing market problem and should have done more earlier to prevent it. This is similar to more general calls for the Fed to be more forceful in the presence of bubbles. Why don't we pop bubbles before they get too big, they ask? It all sounds good in retrospect, there was a lot of talk about unsustainable housing prices long before the crisis and many criticize both Bernanke and his predecessor, Greenspan, for keeping money loose during the amazing home price inflation. The problem with this logic is that the market has built in mechanisms to pop bubbles. If it was so obvious that there was a bubble, where were the short sellers that would have taken the air out of the market? Why wasn't there a flood of short selling on mortgage backed securities, which would have made them much less profitable and would have lessened the demand for new mortgages?

In essence, the bubble popping crowd is saying that a few individuals in the government can do a better job than the 'wisdom of the crowds,' that somehow a few bureaucrats are better able to tell when there is a bubble then tens of thousands of professional investors who have a huge amount of money at stake. I have a hard time buying it. Perhaps the lesson to learn from looking backward is not that the government should step in when there is an obvious bubble, but that the bubble was not at all obvious and government interventions are not likely to do good when they are so hard to pinpoint.

On a related note, many of those that criticize the Fed for not tightening the money supply to cool off the housing market and thus deflating the bubble, have been harsh critics of the TALF and other programs to deal with toxic assets. But these programs are essentially bubble popping programs. If we define a bubble as a price that has become disconnected to some notion of true value, well the justification for the toxic asset program was just that - the price of toxic assets had basically gone to zero while there was still some real value in them. So the plan was to essentially prop up the price of the assets until the panic subsided. This is bubble popping in reverse, if you will. Of course the rationale was different - the Fed felt forced to do the latter to prop up banks that were poised to fail and it wasn't really an intentional bubble popping mission.

At any rate, I, for one, will sleep better with Bernanke still on the job.

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