Which Bubbles Should The Fed Pop?

A few weeks back, I asked whether the Federal Reserve should pop bubbles. There was a nice post on Econbrowser yesterday on the same topic. Like me, its author James Hamilton, appears to believe that there may be instances when the Fed would be wise to pop bubbles, but others where it should just let the market do its thing. Like me, he also worries about how the Fed knows if there's really a bubble. Let's look at these questions a little more closely.

Hamilton scratches his head, asking why the market controlling bubbles isn't enough by short-selling. Obviously, some investors must know that a bubble is forming. He then sort of answers his own question. After defining a bubble as when an asset price goes crazier than it should, he says:

If that's what you believe, then there's a potential profit opportunity from selling the asset short whenever you're sure there's a bubble. And if that's the case, my question for you would be, why don't you do put your money where your mouth is instead of telling the Fed to do it for you? Your answer might be that it could take years for the bubble to pop, and you're not willing to absorb the risk in the interim. Or maybe you don't have the capital to cover the necessary margin requirements while you're shorting the bubble on the way up.

And that's exactly right. From an investor standpoint, your most rational bet is to ride the bubble out. After all, you don't want to be on the losing side of all of those investment gains -- they could last for years. So when you sense that an asset's prices are artificially increasing, then you'd better get in on the game. Besides, the price might not fall as far as you thought once the bubble pops.

This is why the market fails to fix the bubble problem itself. It's about investor psychology. Investors are more like sheep than prophets. When there's a dominant market trend, everyone gets on board. There may be a few here and there that don't believe the prevailing narrative, but they're the exception and not the rule. They hardly move markets.

That's why it's so useful to have someone like the Fed. There, you can have a room of the nation's top economists who can sense when an asset is going irrationally wild and take measures to calm the market down. But it's not always wise to do so, which leads to the next question.

Hamilton says:

Of course, it's easy enough to say what should have been done in 2004. but the real challenge is figuring out what to do in 2010.

So which bubbles should the Fed seek to pop? I'd say big ones that threaten the broader economy. Not all bubbles are a major threat. The tech bubble of the late 90s, for example, didn't hurt many people who lived outside Silicon Valley or didn't own many tech stocks. The housing bubble, on the other hand, brought down the entire U.S. economy and triggered a global recession. Ironically, the Fed popped the first bubble and left the second one alone.

It's not always so difficult to figure out which bubbles are the most threatening. Housing, for example, permeates the entire economy. Real estate affects everything from consumers to investors to banks to government sponsored entities. A certain sector of stocks or a small basket of commodities probably doesn't. For example, if there's a gold bubble, it's probably not much to worry about. Even if it does pop, I doubt the average American will notice much change in his or her life.

Once a bubble's underlying asset is seen as being systemically relevant, the size of the bubble should be considered. For example, if the housing market had gone from a 2% average annual appreciation to a mere 3% or 4% annual return rate, then that's probably not going to be a big deal at two years out. But if you've been having a 5% to 10% appreciation for three years or more, then bad things may eventually happen if that continues. So the asset's importance to the economy and the rate of its irrational price inflation should both be considered.