Sprinkler System

Monday, May 25, 2009

It seems the current academic debate is regulation versus a post-bubble sprinkler system (along with structuring businesses for a "worst-case scenario"). An analysis of the British Railway Mania of 1843 suggests "Although this period was a bubble in the popular sense of the word, in that there was a substantial asset price reversal, it was not a bubble in the economic sense, as railway shares were not obviously mispriced at the market peak."

The instability that has followed the bursting of the housing bubble has led to a renewed discussion about what can be done to prevent the recurrence of financial crises. Cecchetti et. al (2000) have suggested that monetary policy should be tightened when regulators believe assets are overpriced, in an attempt to deflate a suspected bubble before it bursts. However, Bernanke (2002) and Mishkin (2008) have argued that this proposal is not feasible, partly because mispricing is difficult to identify ex ante. Several pieces of academic research have provided a justification for this position by suggesting that assets were not obviously mispriced prior to market crashes in certain historical episodes, such as the Tulip Mania of 1636 (Garber, 2001), the German stock market boom of 1927 (Voth, 2003), and before the Wall Street Crash of 1929 (Donaldson and Kamstra, 1996).

...

It may be better to focus efforts on ensuring stability when the next asset price bust does occur. More attention should be directed to the consequences of sustained declines in asset prices, as capital requirements which are based on short-term market risk may provide inadequate protection against persistent and longer-term falls. It may be useful to introduce some long-term stress testing, which would examine the consequences if the largest peak-to-trough asset price movements in history were to be repeated. If the financial system could not endure some of these historical experiences, then it may need to embrace tighter regulation or restructuring.

The railway mania: Not so great expectations?, Gareth Campbell, May 23, 2009, http://www.voxeu.org/index.php?q=node/3598.

But didn't Friedrich August von Hayek receive a nobel prize for economics in 1974 showing that:

...monetary expansion, accompanied by lending which exceeded the rate of voluntary saving, could lead to a misallocation of resources, particularly affecting the structure of capital. This type of business cycle theory with links to monetary expansion has fundamental features in common with the postwar monetary discussion.

The Nobel Prize in Economics 1974, Nobelprize.org, October 9, 1974, http://nobelprize.org/nobel_prizes/economics/laureates/1974/press.html.

So why is the academic debate about regulating a system in which monetary expansion occurs, or recovering from the popping of a bubble in such a system, rather than the system itself (i.e. the Federal Reserve and fractional reserve banking)?

For something this big and damaging to happen it takes a lot of mistakes over time. And it is that combination of things. Interest rate here and around the world were kept too low for too long...

U.S. Treasury Secretary Timothy Geithner, Geithner Dismisses GOP Socialism Charge as 'Ridiculous', The Washington Post, May 24, 2009, http://voices.washingtonpost.com/federal-eye/2009/05/geithner.html.

Even the U.S. Treasury Secretary, former President of the Federal Reserve Bank of New York, admits that the Federal Reserve screwed up on monetary policy, which in part contributed to the housing bubble.