Wednesday, January 06, 2010


An interesting item by Stephen Bartholomeusz on a speech by Ben Bernanke on monetary policy and the housing bubble.

The question of whether to raise interest rates to stiffle bubbles was a key element in Galbraith's analysis of the Great Crash of 1929. He concluded as has almost everyone ever since that you can't use monetary policy to stiffle asset price bubbles in only part of the economy.

A bubble is really a case where herd pricing overtakes fundamentals pricing and relates only to one asset class. The best regulatory solutio is to include an automatic stabiliser in pridential rules that increases the risk weighting that needs to be applied to specific asset classes if the price of those assets is increasing faster than other economic measures.

But this does not resolve the Fed of blame. Keeping interest rates low is the way to the Japanese economic winter, not to avoiding it. Low rates become a disaster if you suffer a downturn while you have them - because you lose monetary policy as a tool.

That's also why the criticism by th coalition of Government policy that is maintaining fiscal stimulus while there is monetary tightening. The Government and RBA recognise the need to get interest rates back to a "normal level" sooner rather than later so they can be an effective tool.

The Fed's low rates should not be blamed for the bubble and the crash, they should be blamed for the trouble the US will have in getting out of this mess.

Greenspan personally can (and has) take the blame for an excessive belief in the self-correcting characteristic of markets that invaded US policy making.

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