It looks like we were right on topic with this one, as a discussion about whether central banks have to stop bubbles in their tracks seems to have started in earnest even at the Fed itself.

We just came across of what is the best summary of our position (which we wrote in the earlier parts):

“The Fed and Treasury created the housing bubble to get us out of the Nasdaq bubble crash, which they created to get us out of the Y2K gridlock — which never materialized — and to get us out of the 1998 Long-Term Capital Management and Russian default crises,” says Michael Belkin, president of Belkin Ltd., a firm in Bainbridge Island, Washington, that uses quantitative models to forecast movements in financial markets.

So, what is the discussion about. Should central banks pop asset bubbles, and if yes how? Let’s review the two most used arguments against central bank intervention in bubbles:

How to recognize a bubble when it’s building up?

Indeed, that’s difficult, but hardly impossible. The two biggest bubbles, the technology bubble at the turn of the decade and the housing one that is deflating as we speak, were hardly a secret.

Even Alan Greenspan, in his own words, already recognized the bubble in technology shares in December 1996 when he spoke of ‘irrational exuberance’. We repeat, December 1996. He might well have been one of the first to recognize the bubble, too bad he did nothing about it.

We do admit that it’s not always clear-cut though. One example, is there a housing bubble in the UK (and more especially London)? For one, house prices are terribly expensive and kept on growing at a fast pace, losing touch with average earnings.

On the other hand, London especially became not only the premier financial center in the world (overtaking New York), it also became a hub for the rich and famous. The point is, in a globalized world, there is only one London. It’s basically fixed supply, while globalization increases the demand for living there, especially for rich people (normal mortals are increasingly ‘priced out’ anyway).

Is that a bubble? Hard to say, as one can identify real demand and supply factors behind the rise into the stratosphere.

Even if central banks can recognize bubbles forming, do they have the instruments to do so?

This is a more tricky argument. It’s basically true. Interest rates are central banks most important instruments, but they are rather blunt. Targeting bubbles with interest rate hikes could lead to a lot of collateral damage.

For instance, the dilemma in the second half of the 90s was the following: there was no sign of inflation, if anything, new economy forces (higher productivity growth) and globalization (increasing competition from low labour cost economies) were deflationary.

One could argue that there would have been no reason, from a traditional monetary policy point of view, to increase interest rates as there was no threat of inflation. However, there were other signs of excessive monetary laxity even then. Money and credit growth was in the double digits. All that money has to show up somewhere.

And take that UK (or London) housing market example. Should the Bank of England (BoE) have increased interest rates to cool off that housing market, while there was hardly any serious inflation problem elsewhere in the economy?

Probably not. However, that doesn’t mean central banks do not have other means at their disposal. Better regulation would certainly have made a difference in the housing bubble, for instance.

In fact, the authorities in the US went the other way blinded by a rather primitive belief in ‘free’ markets taking care of all problems. We also believe in free markets, however, we recognize that markets can only function well within a proper institutional environment.

If not, markets can, and do, create problems of their own (this is more like thesis material, this is not the place to go into this, but an excellent non-technical treatment of this subject is John Kay’s “The Truth about Markets”)

The European Central Bank (ECB), despite only existing for a decade and the complicating factor of having to manage 15 rather diverse economies, does a much better job.