Asset Bubbles and Their Consequences

In the past, the federal government has introducedmoral hazard in the banking systemthrough deposit insurance. Banks underpricedrisk because of the federal guarantee that backeddeposits. After banking crises in the 1980s and1990s, deposit insurance was put on a soundbasis and that source of moral hazard was mitigated.In its place, monetary policy has becomea source of moral hazard. In acting to counterthe economic effects of declining asset prices,the Federal Reserve has come to be viewed asunderwriting risky investments. Policy pronouncementsby senior Fed officials have reinforcedthat perception. These actions and pronouncementsare mutually reinforcing anddestructive to the operation of financial markets.The current financial crisis began in thesubprime housing market and then spreadthroughout credit markets. The new Fed policyfueled the housing boom. Refusing to acceptresponsibility for the housing bubble, the Fed'srecent actions will likely fuel a new asset bubble.The cumulative effects of recent monetary policyundermine the case for free markets.