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Source link: http://archive.mises.org/10453/how-can-the-fed-prevent-asset-bubbles/

How Can the Fed Prevent Asset Bubbles?

August 13, 2009 by

In his speech at the BIS conference in Basel, Switzerland, the president of the New York Federal Reserve, William Dudley, argued that asset bubbles pose a serious threat to real economic activity. He holds the view that the US central bank should develop effective tools to counter this menace. As things stand at present, said Dudley, a monetary policy that relies on short-term interest rates is not well-suited to deal with the emergence of bubbles. FULL ARTICLE

{ 26 comments }

Old Hop August 13, 2009 at 8:10 am

Note that the trigger for the burst is actually the decline in the growth momentum of money supply. Again, as a rule the decline in the growth momentum of money supply is set in motion by a decline in the monetary pumping by the Fed.

Here is my nagging question: at what point did the Fed decline the growth momentum in the money supply? It seems to me that at some point entrepreneurs realized that the future goods they were creating were not being met, or would not be met, by consumer demand.

Here’s ABCT as I understand it:

A residential builder sees lower interest rates as 1) an opportunity to buy up more resources to build more houses, and 2) a signal that demand for housing is going to be strong in the future. He pours his efforts into building houses — perhaps faster than he can pay his existing obligations. Meanwhile, consumers take cheap money and spend it on immediate consumption goods, or refinance and do home improvements; but savings or demand for new houses is nowhere near the volume the builder anticipated.

I’m having trouble seeing why a contraction in the money supply causes the bust. (Did we even have a contraction?) It seems simple enough that the change in time preference between consumers (high) and entrepreneurs (low) brought on by artifically low interest rates is sufficient to explain why a bust is inevitable.

Help me out.

Patrick Mahoney August 13, 2009 at 9:40 am

“Note that an increase in the growth momentum of asset prices implies an increase in the growth momentum of the money supply. If, for whatever reason, the central bank slows down on the monetary pumping, this leads to a decline in the growth momentum of asset prices. Consequently, some market players are likely to start locking in their profits by selling assets.

Once more and more players begin trying to protect their profits, their actions quickly lead to a bursting of the asset bubble. Note that the trigger for the burst is actually the decline in the growth momentum of money supply. Again, as a rule the decline in the growth momentum of money supply is set in motion by a decline in the monetary pumping by the Fed.”

Hi Old Hop,
A rational actor in the real-estate exchange used is almost like a poker player. At some point in a non-zero sum game, a player has to decide to pick up his stack and leave the table. As we know, increasing the money supply does cause prices to rise artificially. At some point, a player’s stack rises to the point where they are content-the value they receive from cashing out is perceived to be greater than that to be gained staying in the game. Same with housing speculation-prices rise to the point where an owner sees a sale being more profitable than hanging onto the property. The bubble bursts when the housing hits its new threshold, and there are no further buyers willing to buy the property at its new, inflated price. In order for a new buyer to appear, the growth in the money supply needs to continue at at least the same rate-this does not occur unless the interest rate is further dropped. With the interest rate held, the real valuation of the property begins to settle in terms of the value of the currency-it takes time for this to occur. As it does settle, more and more players realize that they are invested too deeply-they start cashing out as well. When they cash out, there is also correspondingly less demand for other purchases-this trend hits a critical point, accelerates and then pop, housing collapse and all its affects on other areas of the economy.
Pat

Old Hop August 13, 2009 at 10:10 am

Thanks for your response, Pat.

I need to clarify my question:

No doubt a sudden contraction in the money supply would, in theory, cause a bust. But when exactly did the Fed reduce monetary pumping? Weren’t rates still low during the meltdown? It seems to me that once malinvestment is set in motion by interest rate-lowering policy, the boom/bust will occur regardless, due in part to demand falling relative to misallocated output.

BigBoy August 13, 2009 at 10:39 am

You can see when it happened from various money supply graphs, interest rate graphs etc.

The key point is: if it doesnt burst by the slowdown of monetary inflation, it will burst from people no longer putting their real savings into the money(ie hyperinflation) from which the savings could go ontop of the bubble.

Michael Orlowski(The Orlonater/ChainedOrlo) August 13, 2009 at 10:56 am

Old Hop,

The contraction in the money supply leads to a bust because the velocity of money in circulation doesn’t equal the boom era equilibrium. Investors have to cut down, or cut their projects completely; they have to lower the price on the already existing assets, and so forth. I’m not an expert in Austrian economics, but that’s my way of putting it. If anybody wants to correct me, do so please.

Nick Bradley August 13, 2009 at 11:37 am

The Fed has announced that they will end their policy of quantitative easing in October — the $300B purchase program will end at that time. In effect, that is a reduction in monetary pumping.

2nd Amendment August 13, 2009 at 11:55 am

“How Can the Fed Prevent Asset Bubbles?”

By staying out of the currency market, by staying out of the loans market…by staying out of the way and ceasing to exist.

Patrick Mahoney August 13, 2009 at 12:06 pm

“No doubt a sudden contraction in the money supply would, in theory, cause a bust. But when exactly did the Fed reduce monetary pumping? Weren’t rates still low during the meltdown? It seems to me that once malinvestment is set in motion by interest rate-lowering policy, the boom/bust will occur regardless, due in part to demand falling relative to misallocated output.”

> I think you are right on the money – the bust from a huge infusion of money will occur regardless, and in proportion to the size of the infusion. In order to avoid the bust, the interest rate needs to be lowered further. When this does not occur, it is a matter of time for the distortion caused by misallocated output to be corrected in the market. Interest rates continued to be low, but unless the Fed continues to drop them the bust will occur.

I think a good analogy is between this inflationary view of the market and a perpetual motion machine. The inflationary theorists always propose that a one-time injection of money can be self-sustaining; its like a hydro-generator that powers itself by pumping water back up to the top of a waterfall. However, like in physics, once the injection occurs, it is only a matter of time before the system runs itself to a stop. At this point, the only way to keep the system going is a new and larger injection of cash (because the mis-allocation destroys capital)-inflation thus accelerates.

-Pat

Dick Fox August 13, 2009 at 12:08 pm

I just don’t know why Shostak introduced FRB except from his prejudice.

He states:

The increase in the production of goods is made possible by securing bank loans, which are expanded out of thin air — that is, through fractional reserve lending.

To understand just consider two situations. First, if there is no FRB is there still the threat of inflation through monetary expansion by the FED? The answer of course is yes. Second, if there is FRB and loans are at their maximum can there be monetary expansion without an increase in supply by the FED? The answer is of course no. The bank has no source of funds so there can be no expansion.

Shostak does admit this in his article stating:

Without the central bank creating new money, banks cannot expand credit out of thin air.

So if that is the case why even bring it up. Clearly it is just based on Shostak’s prejudice against FRB.

George August 13, 2009 at 12:09 pm

It seems to me that it is false that it requires a decrease in the rate
of money growth to cause the crash:

1. There are only so many real goods.

2. The growth of money will cause plans to be put in effect for using
more real goods then exist.

3. At some point (no matter how much money is around) the shortage
of real goods will show up.

4. The plans will come undone…

None of this requires the growth of money to slow the slightest.

It’s likely that even faster money growth will just make the plans
require even more real goods and bring the end faster.

Old Hop August 13, 2009 at 12:29 pm

Patrick –

Thanks again. The perpetual motion machine analogy helps quite a bit. Unless the rate continues to fall, it effectively “rises” relative to investment/spending activity.

greg August 13, 2009 at 4:18 pm

If all the houses built was built with bank funds, we would not have the problems we have today. The problem was all those people with cash that used private money to build specs. During the building boom, I was constantly approached by investors with cash wanting a discount off the contract that equaled my interest and loan fee expense. Basically, they wanted a 10% return over one year.

Investors led by media hype have more of an impact on creating bubbles than anything else. For example, Cramer on CNBC during these boom years would highlight a stock and the price would rocket up for at least 3 days. Then the bubble would burst and it would fall back. Today, his impact has been reduced to about 3 hours.

The problem is the investment world is totally manipulated in the short run by a few. And they are the ones that led the rest of the sheep through the bubbles and bust.

Toby August 14, 2009 at 6:08 am

As much as I loathe monetary expansion, I have to admit that the recent increase in base money supply is not that unreasonable after all.
If you look at this graph, (http://lh6.ggpht.com/_nnevLaVAAGo/SgcHjZSxqcI/AAAAAAAAAHE/l8JoiVryZxI/image4.png) you will see that the stock of money increased from 6000 to about 6600, which is more or less 10%

And this corresponding graph shows that monetary velocity declined by about 10% (http://lh4.ggpht.com/_nnevLaVAAGo/SgcHkdC3Z1I/AAAAAAAAAHM/w_iTabY1Z2E/image4%5B1%5D.png).
So, if Bernanke did nothing, money supply would have decreased in the last months by about 10%, which would have caused a huge shock to the economy.

As long as Bernanke is capable of decreasing the money stock when velocity jumps up again, recent monetary policy might have prevented a major deflationary shock, stabilising our economy.

Carlos Novais August 14, 2009 at 6:29 am

Toby

The decrease in Velocity its not measurable as an independent variable.

It seems that in part the decrease only express the fact that the Monetary Base exploded with the new injections of reserves in the banking system but are not being multiplied yet with new credit and money.

Russell August 14, 2009 at 7:22 am

Monetary expansion interferes with structural readjustment of the economy by sending false demand signals. It does ease the immediate pain but prolongs and exacerbates the problems in the aggregate.

Alex August 14, 2009 at 9:21 am

I notice Frank S says, “AS A RULE, in order for this (asset bubbles) to occur there must be an increase in the pool of dollars, or the pool of money.” This leaves open the possibility that not all asset bubbles are monetarily induced, which I think is correct.

For example, suppose individual A has a $100 deposit at a bank, while individual B has a stock worth $50. Suddenly, erroneous profit expectations lead people to think that the stock is worth $100 (an asset bubble). Suppose A buys the stock and B places the proceeds in her bank deposit. Once actual profit data reveal the expectations’ error, the stock falls back to $50 (the bubble bursts).

The bubble and its bursting was not in any way monetarily induced. The net effect of the process was a transfer in wealth to those who sold the bubble asset prior to the burst (B) from those who hold the asset after its burst (A).

Of course, the conceit in Dudley’s argument about the Fed being pro-active on asset bubbles is that the Fed is smarter than the market and will be able to distinguish between bubble prices and non-bubble prices.

BT August 14, 2009 at 10:55 am

To Dick Fox:

“I just don’t know why Shostak introduced FRB except from his prejudice.”

I think he introduced his “prejudice” because of the importance that FRB plays in credit expansion. Obviously, the Fed is responsible for the initial injection of money (a priming of the pump so to speak), but FRB drastically accelerates the process!!! Depending on the required reserve amount (which I believe is currently at 10%), each dollar injected into the system leads to the possibility of even more dollars created out of thin air. Thus, at a 10% required reserve, the banking industry stands to create a total of $10 from every dollar the FED injects into the system!! (calculation: $1/.1)

To Greg:

“Investors led by media hype have more of an impact on creating bubbles than anything else.”

How can you make this statement Greg? If somebody recommends something and I then desire to have it, I STILL have to come up with the funds to purchase the item (stock, house, commodities, etc.). Where would so many people obtain such money? From easy, low-interest credit that only the FED can provide!!!! If “easy money” wasn’t so readily available, one would think twice before blindly buying something about which he/she knows nothing about (other than a good word from a “guru”). Get the point?

George August 14, 2009 at 4:47 pm

A bubble in one area of the economy without someone printing more money has to result in less money going elsewhere — and thus other prices will tend to drop.

With the printing, other prices don’t have to drop and can even go up.

The printing vastly distorts the economy and costs the people who try to stay away from the bubble.

Russell August 14, 2009 at 6:20 pm

Bubbles are created by people swept up in a herd mentality where there is insufficient transparency or information for people to recognize the bubble.

Bubbles are fueled by Fed injection of credit into a banking system that is permitted to maintain less than a 100% liquid reserve. Get rid of the Fed monkeying with the money supply and partial reserve banking and you will still have bubbles, they will just be much smaller. But this will never happen.

Alex August 14, 2009 at 9:17 pm

But, George, in my example the stock bubble involved people trading money for stocks. The names of those who previously owned the money supply changed, as did the names of those who owned the stocks, but the money supply wasn’t “going” anywhere. The money supply was the same before the unrealistic expectations encouraged some people to think stocks were worth more in money terms as it was after. I don’t see that it’s necessary to have less spending on other goods, services and assets with an unchanged money supply in the face of a non-monetary induced asset bubble. Can you demonstrate this necessity?

Dick Fox August 15, 2009 at 2:52 pm

BT,

You need to take a look at my discussion with Stephan Kinsella in his post Fractional-Reserve Banking, Contracts of Deposit, and the Title-Transfer Theory of Contract two threads before this one. It will help you see the fallacy in you thinking.

One reason that people make the same mistake that you make is because money is fungible. Consider my example of “depositing” a car and it will help you understand. Also consider that “depositors” in a FRB cannot withdraw more than the total of loans plus “deposits” remaining. Attempting to withdraw more will cause the bank to default.

Eric August 16, 2009 at 3:13 pm

Alex,

As George wrote above,

If the money supply remains the same, and the price of some asset (e.g. stocks) goes up, and people buy the same or more of the asset at the higher price, then they are spending more money on the asset.

But you (we) are here assuming that the money supply remains the same, so if more money is diverted to the asset, then less has to be going elsewhere.

BT August 17, 2009 at 11:06 am

To Dick Fox:

Well Dick, I took a look at your previous post with Mr. Kinsella. Unless I am mistaken, Mr. Kinsella also thinks that FRB increases the money supply under the current system (i.e. not free-market). So, is it everyone else who is misinformed, or are you the lone individual who TRULY UNDERSTANDS FRB? Thanks for the “insight”, but I think I will stick with Mr. Shostak’s point of view. Mr. Shostak has more credibility than you. Have a great day!!

perpetual motion machines January 15, 2010 at 2:02 pm

It is trivial when compared to either a simple battery or the energy required to produce the magnet.

39n119w January 20, 2010 at 2:54 am

“I notice Frank S says, “AS A RULE, in order for this (asset bubbles) to occur there must be an increase in the pool of dollars, or the pool of money.” This leaves open the possibility that not all asset bubbles are monetarily induced, which I think is correct.”

would the more stable the pool of money-savings is, the less likely an asset bubble would occur…becuase some other assets would be diminishing due to perceived greater value of the newly funded assets?

39n119w January 20, 2010 at 3:17 am

“the US central bank has lowered the federal funds rate from 5.25% in September 2007 to the current level of 0%. Since September of last year, the Fed has boosted the pace of money pumping through an aggressive expansion of its balance sheet. (The Fed has been buying assets and paying for this with money out of thin air).

As a result, the yearly rate of growth of Fed’s balance sheet jumped from 3.9% in August 2008 to 152.8% by December of that same year. The size of the balance sheet climbed from $0.9 trillion in August 2008 to $2.1 trillion by April 2009.

In response to all of this pumping, the growth momentum of monetary measure AMS has accelerated. The yearly rate of growth jumped from 1.8% in August 2008 to 14.3% by June of this year.

The question that needs to be addressed is this: how can massive monetary pumping and bottom-level interest rates possibly prevent an economic disaster? Careful analysis shows that all these actions can do is to redistribute existing real savings — that is, real wealth — which is necessary to support economic activity.”

i dont know if this is true or not. somehow a federal reserve policy decided to turn very differerent and increase their balance sheet by over 150 percent??
as a surprise??

if the federal reserve mixed its assets (long term and short term, i assume they do) and set an interest rate at known historical gold money increase rate….would problems that arise from the central bank contracting the supply of credit be wiped out?

avoiding the weakening of wealth (a bad thing?) as the author says??

again, if the above is true..i have also been told that commercial banks are just sitting on massive amounts of reserves for….what reason???

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