Former Federal Reserve Chairman Alan Greenspan said it’s impossible to know that you are in a bubble when you are in one. It isn’t impossible for most of us, but it sure seems to be tough for the Fed. Federal Reserve Vice Chairman Donald Kohn who seems to have the same problem:
Kohn said it’s wise to beware of "false positives" when assessing potential asset bubbles, such as with rising stock or commodity prices. A Fed action to correct a bubble might include hiking interest rates, which could harm a wider financial recovery, he said.
Why is it so difficult for the Federal Reserve to see when asset prices are out of whack with fundamentals? Or is it perhaps that admitting bubbles exist would require them to make unpopular choices in policy?
“Why is it so difficult for the Federal Reserve to see when asset prices are out of whack with fundamentals?”
I think it’s twofold – first, these guys are rich. They’re already out of touch. The more you make, you don’t have to worry about essentials – you don’t need to check your budget before you go out to eat, or buy a new car, etc, and the further you go that way the less you think about how other people do.
Add on top of that too much school and not enough real-world experience (see above!), and these guys are clueless to reality. The world isn’t fitting into their formulas, and they can’t understand why these unemployed people aren’t spending money like the math shows they will.
At least, thats giving them the benefit of the doubt. The pessimistic side of me says they know what they’re doing isn’t working, but their egos are too big to admit they are wrong and change their plan. I’ve met several people like that.
[I]s it perhaps that admitting bubbles exist would require them to make unpopular choices in policy?–twist
Yes, but there is more to the story.
The Federal Reserve can not determine the correct price of credit–interest rates–any better than it can set the price of milk, gasoline, bread or cigarettes.
Bernanke is often praised as a shrewd observer of US economic history, yet if there is any substance to this claim, he must have seen Gresham’s law (money seeks its highest “use value”) come into operation during that period when fixed exchange rates governed silver and gold.
When silver became undervalued compared to gold, it was gradually driven out of circulation, forcing gold coin owners to accept less than par value for their holdings. This phenomenon exposed the mistake of fixing the price of gold too high in comparison to silver.
Today, under a fiat regime, credit is often undervalued. This causes entrepreneurs to eagerly bid for it.
They will use this cheap credit to bid up the price of labor and commodities. A boom ensues. Alas, the mistake is discovered when prices are bid up beyond a point where the market can absorb these new, higher priced, factors of production. A bust follows.
The only remedy for these painful boom/bust spasms is taking control of credit away from the central bank cartel and placing it in private hands.
In the recent bubble, the housing market was going nuts, but the job market and the rest of the economy were not doing that well. Tightening rates enough to discipline the housing market would have kicked unemployment into the double digits. The Fed has little leverage to affect one sector of the economy separately from the others.