Bubble-Boom and the Necessary Role of Central Banking

President_Barack_Obama_meets_with_Federal_Reserve_Chairman_Ben_Bernanke_4-10-09In a perceptive comment on yesterday’s Daily, “Bernanke’s Legacy: A Weak and Mediocre Economy”, mkm writes:

Whilst the Fed and Bernanke had a role in the 2008 financial collapse, we should not forget the other actors who were probably more culpable than them. They will include the social pressure groups who pushed for the 70% house ownership policy; the politicians who supported it for electoral reasons; the credit institutions who encouraged and stoked it for person gain; the Government and Legislative institutions who failed in their duty to control it; and the accounting/legal authorities who failed to have in place mechanisms/accounting rules and practices appropriate to control the malfeasance which has been well documented in the past. This is not just a matter for economists.

However, without central bank actions or other special privileges for fractional reserve banks which allow sustained credit creation, bubbles are relatively self-contained with most damage limited to those who make bad ‘investment‘ decisions.

Roger Garrison, as he often is, is right on in his analysis of the relative role of the mortgage-housing  specific aspects of the recent crisis and the role of the Fed. From his Alchemy Leveraged: The Federal Reserve and Modern Finance:

Unsound as these policies were, they were not the principal cause of the financial crisis. Again, Dowd and Hutchinson are right in identifying the expansion-prone Federal Reserve as the principal institutional cause. Had the Fed provided no fuel for the boom, federal housing policy, though perverse, would not have been unsustainable. The mortgage market would have had to compete with all other markets for the funds that savers provided. There would have been a continuing bias in favor of the mortgage market, and the ongoing rate of foreclosures would have been higher. House prices would have been higher (because houses and mortgage loans are complements), but they would not have been high and rising. Practitioners of modern finance would have paid due attention to the higher VaR, which would have reflected the expectation of an ongoing higher foreclosure rate. Conversely, had the federal government not enacted legislation and created institutions that rigged mortgage markets so as to increase home ownership, credit expansion by the Fed would nonetheless have created an artificial boom, which inevitably would have ended in a bust.

And

Although Fannie, Freddie, and related federal legislation are not the principal cause of the crisis, they do account for the particular character of the preceding boom and hence for the particular character of the subsequent bust. The terms boom and bubble are often used interchangeably in the literature on business cycles. It may be preferable, however, to use boom—or more specifically artificial boom—to refer to the credit-induced simultaneous expansion to various degrees of different interestsensitive sectors of the economy and to use bubble to refer to the artificial boom’s most dramatic manifestation. Which sector reveals itself as the bubble depends on the circumstances in which the credit expansion occurs. As indicated earlier, artificial booms entail a turbocharging of whatever else is going on at the time.

Again the best solution to boom-bust is prevention, not clean-up after the fact, which no matter what action or non-action (see Pierre Lemieux’s Somebody in Charge: A Solution to Recessions?) is chosen involves unnecessary painful readjustment. In general, market -based (non-action) are in the long run less painful. See Recessions: The Don’t Do List.

Comments

  1. If the government had not been irresponsible in spending would the Federal Reserve been irresponsible in its credit creation? An associated question, if the Federal Reserve had been irresponsible in credit creation but the government had been responsible in its fiscal responsibilities would there have been a boom-bust?

    To answer these questions let’s consider that the Federal Reserve engaged in a massive increase in the money supply after 2000. Then in 2008 when the economy collapsed the Federal Reserve continued its massive increase in the money supply. Prior to 2000 we saw the boom. After 2008 we did not see the boom. Yet, the money supply expanded in both environments.

    Now what if the Federal Reserve had been responsible and controlled the money supply but the government had been irresponsible in spending? There would have been economic troubles but they would have been restrained and the government would have been forced into responsible spending.

    What this tells us is that the problem came from government irresponsibility but it was made worse and perpetuated by the Federal Reserve irresponsibility. The alcoholic finds it difficult to continue his habit if he does not have a enabler. The governemnt and the Federal Reserve are co-dependents in causing a financial crisis. It seems that to understand the government should be seen as the alcoholic and the Federal Reserve as the enabler. Each constibutes.

    • “…but the government had been responsible in its fiscal responsibilities would there have been a boom-bust?”

      Certainly. The answer lies in the statement “…bubbles are relatively self-contained with most damage limited to those who make bad ‘investment‘ decisions.”

      Just because the government spent on housing does not make it a bad investment for the investor. The government could buy houses and burn them not affecting the supply. It may actually be foolish not to invest. Although wealth is destroyed, it would make the house builder a nice return.

      The problem with the fed is it misleads ANYONE making a bad ‘investment’ decision from knowing it’s a bad investment. Without the government a house builder tries to project how many houses will be needed and how big they need to be. With interest rates lower than what the market would support builders think people can afford more and bigger houses. Normally when an oversupply of houses occur builders will have difficulty selling them and have to discount them. They will then start to lose money causing difficulty repaying the financing. This is a higher risk to a financer so the interest rate for financing a home will go up telling the builder to reduce the supply.

      The fed prevents this monetary communication from happening. Even without the government encouraging housing the market may overinvest and there will be nothing to tell them they were wrong. The only thing the government may have done is make it much more likely to have happened in housing.

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