20 Oct 2008

Should the Fed Burst Bubbles?

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The prevailing wisdom among Fed academics used to be “no,” but now that is changing. (If we’re throwing out private property, we might as well look at some other principles to jettison too.) I summarized my views on the issue in response to Tyler Cowen’s remarks on the WSJ article linked:

Cowen: Should the Fed burst bubbles? Maybe in its role as regulator, if not monetary policy.

Murphy: If one thinks that the Fed created the housing bubble, then the above two sentences are truly scary. It would be akin to Richard Nixon saying, “What’s the story with these rising prices?! We’ll combat them through legislation, if not monetary policy.”

Tyler, I realize you think Greenspan’s negative real interest rates were, at most, necessary but insufficient conditions for the housing boom. Fair enough. But even if you think it really was “market failure” that caused the present mess, I am continually surprised at how easily you throw out the suggestion that maybe regulation X or regulation Y, or a few hundred billion here or a few hundred billion over there, will make things better, going forward.

Do you actually trust the real human beings who are in DC right now, or who will be in there after the election, to implement a Pareto improvement? Did you hear Obama and McCain talk about their, shall we say, nuanced endorsement of free trade in the last debate? (Hint: It doesn’t include cocaine imports for McCain, and it doesn’t include car imports for Obama.) And one of these two clowns is going to correct the flaws in second-best outcomes due to asymmetric information in the financial markets?

Incidentally, if you read the WSJ story, you’ll find this asinine paragraph:

The Fed’s view on bubbles helped fuel what became known as “the Greenspan put” — the conviction among investors that the Fed would let them take excessive risks and step in as custodian if the bets they made went awry. By giving market participants an incentive to assume greater risk than they would have otherwise, the Fed’s laissez-faire position on bubbles may have contributed to the surge in credit that helped push housing prices skyward in the first half of this decade.

Got that, everyone? Now “laissez-faire” includes: A situation in which the central bank will expand the money supply in order to prevent Wall Street investors from being burned by risky bets.

And this is the Wall Street Journal. It would almost be a challenge if this were all a grand conspiracy to undermine the free market, but I think 95% of it is sheer laziness / sloppiness.* Eh, what’s the big deal? Who cares what words “really” mean? Everyone else is talking like that, we all know what we mean. Our article was double-plus-good.

* And yes, technically they said “laissez-faire position on bubbles.” But again, if the bubble is caused by the Fed itself, then this is still a rather odd way to phrase it. To borrow an analogy from Rothbard, it would be like allowing the Post Office to jack up rates on First Class stamps to $1, and then calling that “laissez-faire.” Now that I mention it, I don’t see why Paulson doesn’t hop on board. He’s against price controls, for heaven’s sake!

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