The beginning of the end of irrational exuberance?

Greenspan's Legacy has been the implicit "Greenspan Put" put in place by his hands-off approach to regulatory banking practices. This put, still disputed as a matter of fact, is seen by many as being a floor by which markets, both stocks an bonds, were infused with moral hazard by means of inflated risk taking since, in the view of the put, the Fed would underwrite any market setbacks.

Greenspan's only real comment on the subject was to the effect that the Fed had no special wisdom or expertise that it could effect to burst bubbles, but was most adept at cleaning up after them, so would tend to shy away from the former and flex its muscle only when it was time to do the mopping up from burst bubbles.

Which is interesting from the one incident when he was tagged with creating a major market downturn after uttering the infamous phrase "irrational exuberance" in a speech in 1996.

I'm sure that market response surprised him more than anyone, as it is hard, in retrospect, to see what there was in the speech that showed any attempt to pop a bubble. Perhaps, it was, all along, just the market's way of seizing on anything of enough moment as an excuse to take the steam out of any excessive movement, as markets do all the time, and especially are they likely to do that to the downside, as in 1996, when there is less moral hazard than was thereafter created by the shell-shocked Greenspan, who wanted no further part in any such "interventionist" behaviour, real or imagined.

The speech was actually quite bland, even for Greenspan, concerning merely "some personal perspectives on central banking", dealing primarily with the history of same. And, typically Greenspan, he spoke with both hands. On the one hand he noted,

[the] purpose [of the Fed when it was created] was to "furnish an elastic currency, . . . to establish a more effective supervision of banking in the United States, and for other purposes." Monetary policy as we know it today, was not among the "other purposes"

and on the other hand he said,

The Federal Reserve's most important mission, of course, is monetary policy.

His speech focused on the issues of maintaining stable prices through economic cycles. But, in his professorial way of asking more questions that he proffered answers, said

But where do we draw the line on what prices matter? Certainly prices of goods and services now being produced--our basic measure of inflation--matter. But what aboutfutures prices or more importantly prices of claims on future goods and services, like equities, real estate, or other earning assets? Are stability of these [future, expectational] prices essential to the stability of the economy?

It was in that context that he uttered the infamous phrase, "irrational exuberance", but he did so in a way that, first, largely went unheeded subsequently, even by the Fed, and, second, limited any concern over it to an issue of monetary policy, and not an issue that would implicate the necessity of using any of the other instruments of central bank authority or responsibility. He said,

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? ...

[W]e should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.

He never addressed an answer to his questions, so they must have been more rhetorical than fundamental. But, ironically, particularly in light of the way risk management blew up in the immediate post-Greenspan era, he did say

the substantial changes under way in bank risk management are pressing us to continuously alter our modes of supervision and regulation to keep them as effective and efficient as possible.

Most importantly, all of our recent initiatives, especially the strengthening of the payments system and supervision, are critical to a central mission of the Federal Reserve, to maintain financial stability and reduce and contain systemic risks. This mission is an extension of our monetary policy.

Along with our other central bank colleagues, we are always looking for ways to reduce the risks that the failure of a single institution will ricochet around the world, shutting down much of the world payments system, and significantly undermining the world's economies. Accordingly, we are endeavoring to get as close to a real time transaction, clearing, and settlement system as possible. This would sharply reduce financial float and the risk of breakdown.

Our country can not enjoy the long-run "maximum employment and stable prices" objectives we are given for monetary policy if the financial system is unstable. In this regard, the successes that most please us are not so much the visible problems that we solve, but rather all the potential crises that could have happened, but didn't.

But now, to address the question in the title to this post, the Bernanke Fed is poised to re-examine the Greenspan hands-off-putting approach to irrational exuberance, with, perhaps, an eye to mitigating what could be perceived as damaging effects of mounting asset price pressures of the hard-to-justify if not irrational and enlivened if not exuberant variety.

Thus sayeth this Bloomberg piece, commenting on the most recent Bernanke speech before the Economic Club of New York:

Bernanke Foreshadows End to Fed's Hands-Off Approach to Bubbles

Federal Reserve Chairman Ben S. Bernanke signaled an end to the Fed's decades-old aversion to interfering with asset-price bubbles as the financial crisis reshapes some of the central bank's most firmly held views on regulation and monetary policy.

Officials should review how supervision and interest rates can tackle the "dangerous phenomenon" of bubbles in housing, stocks and other assets that risk bringing the entire economy down, Bernanke said yesterday. He also warned that banking may be concentrated in too few hands even as mounting losses and corporate failures push lenders into mergers.

"There is no doubt that as we emerge from the current crisis that we are all going to look very hard at that issue and what can be done about it," he told the Economic Club of New York in response to a question after a speech.

For two decades, the ruling philosophy was that of former chairman Alan Greenspan. "It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization," Greenspan told the American Economic Association in 2004.

His successor, Bernanke, and his team now find themselves reconsidering their approach to everything from regulation to state ownership.

Now, policy makers will toughen their response to "excessive leverage," give more weight to financial stability in economic analysis and examine ways to strengthen the system of trading and settlement behind complex derivative securities, Bernanke said.

The WSJ also had some thoughts on the Fed re-think:

While it is too soon to pronounce an about-face in Fed thinking, policy makers' views clearly are evolving. The Federal Reserve's longtime line on financial bubbles has been that they were impossible to identify. Even if the central bank could identify a bubble, policy makers said, trying to lance it would be far worse for the economy than letting the bubble run its course and dealing with the consequences.

"[T]he degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy," former Fed Chairman Alan Greenspan said in 2002.

Identifying bubbles is tricky, with some seemingly irrational price spikes turning out to be justified. Policy makers need to be careful of valuing their judgment over the collective judgment of the market, because efforts to quash prices could interfere with the crucial role markets play in relaying information and allocating capital.

In recent years, economists have made headway in identifying incipient bubbles. Princeton University's Jose Scheinkman and Wei Xiong have shown how bubbles lead to overtrading -- whether day trading dot-com stocks or flipping condos -- and this might be a useful alert. Researchers at the Bank for International Settlements have flagged excessive credit growth signaling a bubble.

Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.

Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.

"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said.

Guambat reckons that the way to deal with the pricks who cause the bubbles is by regulation, and the prejudice of economists to look to monetary tools to do so fails to aim the water on the fire and has proven to be out of proportion (both overkill and underkill) to the particular problem du jour. Consequently, Guambat reckons the Fed ought to be wary of Wall Street criticism that "rules don't work" or "we're too smart for your rules" or "stick to your monetary knitting". Or anything else in " ".

IF the Fed is now going to give a hard look to bursting bubbles, even in the current meltdown madness, they could have a test run of THIS BIT of obviously irrational exuberance.