Cato Institute
Briefing Paper
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Asset Bubbles and Their Consequences
by Gerald P. O'Driscoll Jr.
No. 103
May 20, 2008
Executive Summary
In the past, the federal government has intro-
nouncements by senior Fed officials have rein-
duced moral hazard in the banking system
forced that perception. These actions and pro-
through deposit insurance. Banks underpriced
nouncements are mutually reinforcing and
risk because of the federal guarantee that backed
destructive to the operation of financial mar-
deposits. After banking crises in the 1980s and
kets. The current financial crisis began in the
1990s, deposit insurance was put on a sound
subprime housing market and then spread
basis and that source of moral hazard was miti-
throughout credit markets. The new Fed policy
gated. In its place, monetary policy has become
fueled the housing boom. Refusing to accept
a source of moral hazard. In acting to counter
responsibility for the housing bubble, the Fed's
the economic effects of declining asset prices,
recent actions will likely fuel a new asset bubble.
the Federal Reserve has come to be viewed as
The cumulative effects of recent monetary poli-
underwriting risky investments. Policy pro-
cy undermine the case for free markets.
Gerald P. O'Driscoll Jr., senior fellow at the Cato Institute, was formerly vice president and economic advisor at the Federal
Reserve Bank of Dallas.
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