In light of the recent asset price implosions and failures of large investment banks, should the Fed try to pre-emptively prick asset price bubbles? Furthermore, should the Fed be vested with the responsibility of regulating all financial institutions? Short answer: "no" and "no."
The "Greenspan doctrine" on monetary policy says that the Fed should not attempt to check asset price surges ahead of time but just manage the aftermath if they turn out to be bubbles and eventually burst. Such bubbles are difficult to detect before they actually burst, and a consistent policy intended to check presumed bubbles would reduce the economy's long-term growth potential. The job of regulating asset prices rests with market participants whose interests motivate self-regulation against undue market-risk exposures.
But in a speech last week, Fed governor Don Kohn said that "central banks are being encouraged to 'lean against the wind' in the face of asset price bubbles. We need to be honest about our very limited ability to assess the 'fundamental value' of an asset or to predict its price. Research should help to identify risks and inform decisions about the costs and benefits from a possible regulatory or monetary policy decision attempting to deal with a potential asset price bubble."
This suggests a re-thinking of the Greenspan doctrine within the Fed. The recession that began in 2007 has been enormously costly in terms of output and job losses. It is not surprising that Fed economists are examining whether monetary policy could prevent such episodes in the future instead of simply "mopping up" after the fact.
It's well known that the Fed successfully averted economic meltdowns after Wall Street swooned on several occasions: the stock market crash of 1987, its intervention to resolve the LTCM failure during 1998 and the even sharper bursting of the stock price bubble in 2001.
However, memories of those "successful" Fed interventions may have spurred even larger subsequent surges in asset prices because of their moral hazard effects on investor attitudes toward risk. Although other factors such as ratings errors and improper SEC regulations were important contributing factors, the recent financial collapse would not have been as severe without prior Fed-induced moral hazard among investors. So should the Fed now be formally vested with the responsibility of containing asset price bubbles pre-emptively and regulating financial firms?
Economists have long lamented problems in assessing whether asset price increases constitute bubbles and in predicting the timing of asset price bubble bursts. Setting capital standards and ancillary regulatory frameworks for financial institutions is more art than science. Given economists' poor predictive ability in evaluating macroeconomic risks and setting appropriate capital buffers for financial institutions, the Fed is bound to eventually (and spectacularly) fail at preventing asset price bubble bursts followed by severe financial disruptions. Then calls for congressional investigations and oversight on monetary policy would threaten the Fed's independence.
Indeed, making the Fed a financial super regulator would only provide formal sanction to policies that have increased moral hazard effects in the first place. Once the current recession is over and the Fed has withdrawn its extra-normal initiatives to restore credit markets, the correct policy approach may be to do the exact opposite — to signal that there will be no super regulator for financial institutions and to formally prohibit the Fed from engaging in bailouts of non-bank financial firms. Such a formal stance by Congress on financial regulatory policy is the best bet for developing mechanisms for sustained and effective self-regulation by market participants.
Fed officials are probably well aware of the dangers of accepting responsibility for setting financial regulatory standards and using monetary policy to prick asset price bubbles. The dangers are in setting anti-bubble policies that are so draconian they reduce the economy's long-term growth potential and eventually fail to protect financial institutions and the economy from a large macroeconomic shock. Such failures could permanently compromise the Fed's independence in monetary policymaking.
Although Fed analysts will doubtless continue research on the causes of asset price bubbles, they would be foolish to accept formal responsibilities for pre-emptively containing asset price surges and becoming financial super-regulators.