Recession proves asset price bubbles should be popped: San Francisco Fed

Central banks should consider using the Great Recession as a justification for popping future asset price bubbles before they lead to future meltdowns, Federal Reserve Bank of San Francisco analyst Kevin Lansing said in a report released Monday. Lansing’s report, which is titled “Gauging the Impact of the Great Recession,” concludes the 2001 recession was short-lived due to families tapping into home equity and an influx of home sales driven by unsophisticated buyers who were able to obtain cheap credit. The downside to the quick-turnaround in the early part of the decade is the fact a hyper-focus on housing inflated asset prices, creating an unsustainable bubble that eventually led to a much larger downturn in the latter part of the decade, the report contends. “The extensive harm caused by the Great Recession raises the question of whether policymakers could have done more to avoid the crisis,” Lansing argued. Lansing says prior to the 2008 meltdown, Fed policy under Greenspan focused on letting bubbles run their natural course. He cites the Greenspan strategy as one where central bankers addressed the “bubble’s consequences rather than the bubble itself.” He says monetary policymakers base this view on the belief it’s difficult to identify a bubble in real time. However, that’s an assertion Lansing challenges in his report. “Some economists argue that bubbles can be identified in real time if central banks look beyond asset prices to other variables that historically have signaled threats to financial stability, such as sustained rapid credit expansion,” Lansing wrote. “If the economy is indeed robust and the boom is sustainable, actions by the authorities to restrain the boom are unlikely to derail it altogether. By contrast, failure to act could have much more damaging consequences,” he said. Lansing points to the recent U.S. Financial Crisis Inquiry Commission which found there were clear warning signs before the meltdown. Some of those red flags included a dramatic upswing in risky subprime lending and securitization, an unprecedented rise in home prices and reports of widespread predatory lending practices. When it comes to preventing bubbles, Lansing does not celebrate regulation as much as he focuses on the need for an active fed policy. “Many have argued that a central bank’s interest rate policy is too blunt an instrument and that regulatory policy is better suited to restraining bubbles,” he wrote. “However, regulatory policy may not be a magic bullet. Unfortunately, regulations put in place after a crisis to prevent bubbles are often relaxed as complacency sets in, opening the way for the next bubble. Interest rate policy may have a distinct advantage because vigilant central bankers can deploy it against bubbles regardless of the regulatory environment.” Write to Kerri Panchuk.