Let me provide some background for the larger context of this post. A commenter and I recently had the following exchange in the comments following a post here:
I did not answer in the comment section, but I did put the following hasty thoughts together in an email sent to Wanna later:
Philosophically speaking boom and bust are a way of life and that is the way it should be. Fed should not try to anticipate a boom and nip it in its bud. How would the Fed know in advance that a bubble is going to happen. These things are evident only in hindsight (which of course is 20/20 for TV and market pundits). Fed's job as Greenspan and Bernanke have said before should be that of a mopper rather than a boom-breaker.
Why is it that "boom and bust" is the way it should be? Would it not be better to target steady, sustainable growth rather than extreme run-ups followed by sharp letdowns over and over?
By suggesting that "Would it not be better to target steady, sustainable growth" you are probably saying that Fed knows two things: 1. the number for steady, sustainable growth. Is it 3% per year, is it 5% per year, is it 8% per year? Which number should Fed use? Depending on which number you pick then the next question is 2. How do you know that is a correct number? China is growing at more than 8% per year. Should Chinese Fed have tried to rein in this party long time back because 8% is such a big number?
This is similar to Monday morning Quarterbacking. Most people's hindsight is perfect.
Mopping up post party is much better than reigning in the party prematurely.
I think you make a good point that setting targets is difficult, but at the same time, directly reigning in bubble-like growth isn't necessarily the idea. Instead, I go back to regulatory reform. One example: If there was proper oversight on ratings agencies so that they couldn't rate a big collection of junk as AAA quality when it should have been B or worse, much of the rampant real estate speculation and associated market tools could never have been exploited to the degree they were. This would have indirectly limited the extent of the bubble. Perhaps then, the comments shouldn't be aimed at the Fed, but at the government in general. Basically, I don't see how a bubble like the tech bubble could have been prevented: that was pure speculation that I can't think of reigning in, because it was due to an extremely bullish, forward-looking investment sentiment that was just the market being silly. This more recent bubble might have been less bubble-like if regulations were in place to limit financial "innovation" that really just took advantage of bad gov't. Keep in mind that it also allowed banks to reduce capital requirements which is a more dangerous state of affairs than what existed during the tech bubble. So, you're right: the Fed's job is to clean up after the mess and regulation reform is outside Fed purview. But smart regulation could perhaps mitigate *some* bubbles, which is better than letting them all through. I wonder if the S&L crisis was exploitation of similar gov't inadequacy. Let me predict that your counter will be that there will always be loopholes we will only see in retrospect, and the gov't will thus perpetually be inherently inadequate. I hope this is not true, and I wonder if it comes back again to the lack of financial literacy in the public. If this literacy rate was higher, perhaps financial "innovation" would be more transparent and idiocy would be caught more quickly.
p.s. Wanna's response was indeed that gov't will always be inadequate. I can't dispute that. Not all bubbles can be prevented, not all idiocy can be controlled. However, the government has a responsibility to control what it can. One thing it can control is transparency of ratings given by ratings agencies: it can be argued that these ratings fueled much of the equity market bubble by enabling all the exotic "financial innovations" Wall St. put together during that time. Also, buried in the guest post made yesterday, is a paper from the Dallas Fed arguing against Wanna: it is imperative that we not simply sit back and clean up after the party.
As such, there are two solutions that I see: one, as mentioned in other posts in this blog, is financial literacy. This is a topic that probably goes beyond the scope of this blog, as that seems more like educational policy than anything else. The other is regulatory reform, which I've been hammering at for a while. Congress investigating Moody's is a step in the right direction on that front, though Congress should look at regulation of all various financial institutions and do their best to ensure transparency on all issues. Going after ratings agencies should be one step in a larger, broader process.
Throughout the financial crisis, major credit-ratings firms were criticized for their overly rosy ratings of complex debt securities, which deteriorated soon after and led to billions of dollars of investor losses.
Despite months of regulatory scrutiny and some internal changes at the firms, a recently departed Moody's Corp. analyst says inflated ratings are still being issued. He has taken his concerns to congressional investigators.
The analyst, Eric Kolchinsky, said Moody's Investors Service gave a high rating to a complicated debt security in January 2009 knowing that it was planning to downgrade assets that backed the securities. Within months, the securities were put on review for a downgrade.
"Moody's issued an opinion which was known to be wrong," Mr. Kolchinsky wrote in a July letter to the rating firm's chief compliance officer, a copy of which was reviewed by The Wall Street Journal. In the letter, Mr. Kolchinsky cited other instances in which he believes inflated ratings were given to securities.
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