David Leonhardt’s column today in the New York Times, in reaction to Ben Bernanke’s recent speech at the American Economic Association meetings, asks an important question:
If the Federal Reserve failed to detect the housing bubble when it occurred, why should we entrust it with that role in the future?
But he doesn’t follow the logic of his question far enough and instead embraces a financial equivalent of the National Transportation Safety Board, as if technical solutions exist and could be implemented if politics got out of the way.
In our recent Policy Analysis, Jagadeesh Gokhale and I examine a more complete list of technical and political problems that stand in the way of asset bubble management. Can bubbles be detected using scientific techniques (econometric models) with little controversy? We argue no.
Would stopping bubbles involve the simple implementation of a technical solution such as raising interest rates, or would they instead involve trade-offs with other policy goals? We argue the latter.
Even if bubbles could be detected easily with no controversy and policy solutions involved no tradeoffs, could the Fed maintain political support by stopping booms if the benefits of such a policy (preventing busts after financial bubbles burst) were never observed? We argue no.
And finally, even if all the previous problems were solved, how would raising interest rates reduce the supply of capital to housing markets given that a rate increase would increase the supply of capital to the United States and interest rates for both long-term and short-term housing loans have become decoupled from federal funds rates?
Our reasoning, like Bernanke’s, suggests that the events of 2008 were not the result of “bad” monetary policy. However, we believe that granting additional regulatory authority to the Fed will not prevent similar episodes because of the technical and political difficulties we describe in our paper.