In the previous episodes (partI, II, III) we saw how ‘new economy’ forces increased productivity and flattened the business cycle, and restricted inflation more or less to asset markets. This set in motion a wholly new dynamic with asset market bubbles threatening financial and economic stability. How do central banks respond? We discussed the Chinese model in part III, now the American model.

The American model
Well, for now, this pretty much seems to be a bubble cycle. Originally, notwithstanding Alan Greenspan’s famous “irrational exuberance” qualification of the markets back in December 1996, the Fed did seem to take it’s eye of the ball in the years after that.

Blinded by the talk of a ‘new economy’, they were apparently unaware, or not willing, to do anything about glaringly overvalued prices in technology stocks. In a way, it’s defensible.

Most central banks have as their prime concern to maintain the value of the currency. This is primarily the internal value of the currency (it’s purchasing power, hence keep prices stable, that is, keep inflation under control).

Some, especially small open economies, are more directed toward the external stability of it’s currency, its exchange rate vis-à-vis the currencies of its main trading partners.

The Fed has an attitude of ‘benign neglect’ towards the latter (it rarely intervenes in the currency markets to prop up the dollar), so it’s mostly inflation they’re concerned about.

And there wasn’t a whole lot of inflation to be concerned about. In fact, the higher productivity growth those new economy forces brought made inflation less of a danger (and upcoming China also had a deflationary effect, as did a rising dollar).

But it depends what you consider inflation. In terms of the typical basked of consumer products (the consumer price index, or CPI, the most commonly used measure of inflation), it was benign, but in terms of asset prices, there was rampant inflation.

And monetary policy was very loose, there was double digit growth for credit and money creation (the two are connected, so that’s no surprise) that would make other central banks think twice. But that’s the disadvantage of inflation targetting.

To the Fed’s defense though, using monetary policy to deflate asset price bubbles was (and to a considerable extent still is) a controversial idea. It’s not entirely obvious when one could unequivocally say that there is a bubble in the first place, for instance.

However, as with normal inflation, asset price inflation is easier to prevent than to cure. It’s a genie out of the bottle, so to speak.

But the bubble could blow up unhampered, until it got totally out of proportion and imploded under it’s own weight. The ensuing fallout was pretty hefty, since early 2000 was a time when one could get tips about the latest hot internet stocks from one’s hairdresser, and taxidrivers were daytrading between trips, in short, things had gotten out of hand pretty badly.

Then, apart from higher productivity growth and a wall of cheap imports from China, deflationary forces became so strong that the Fed started worrying about deflation, not inflation. It lowered interest rates drastically, that avoided a big recession, but helped inflate the next bubble.

That cycle seems to repeat itself now, as once again we have a bursting bubble (housing) met with aggressively losening of monetary conditions by the Fed.

If every period of excessive speculation and asset market inflation is met with a central bank bailing out investors, this might make things worse in the future. A so called ‘moral hazard’ problem might be created.

Basically, investors could be counting on drastic action by the Fed, which cuts part of the risk of inherently risky investments, inflating bubbles even more.

Another issue that might have been looked into is the incentives facing bankers. Basically, it looks like many face one-sided risks. If their very speculative bets pay off, their option charged incentives pay-off big time.

When they do not, what do they lose? A couple of these people lost their jobs, but even that doesn’t seem so bad considering the compensation packages and pension benefits that are often attached to this.

It’s only a little exaggeration to state that basically, profits are private, but losses are socialized, and the means by which this happens creates the fuel for the next bubble.

The 64.000 dollar question is, where is the next bubble blowing? Could it be in commodities? In fact, if that happened, we would come full circle, as that will trigger real inflation, not just asset price inflation. And it’s already starting to happen..