At the Washington Post it seems that missing the largest financial bubble in the history of the world is a necessary credential to discuss Federal Reserve Board policy. The Post notes that the economy's horrible performance over the last decade, which was caused by the collapse of the stock and housing bubbles, and then turns to Fed Vice Chairman Donald Cohen to hear an argument that the Fed should not use monetary policy to prick asset bubbles. Actually, at least some of us who warned of the bubble and wanted the Fed to stem its growth before it became too dangerous urged the Fed to first and foremost take up the same warning. If the Fed had devoted its full research capabilities to documenting the existence of the bubble and the potential dangers from its collapse and the Fed used its enormous public platform to highlight this research, it is likely that this would have been sufficient to burst the bubble. In any case, given the small cost of this action versus the trillions of dollars of damage caused by the bubble, this should have been a no-brainer. In addition, the Fed had regulatory authority to curb many of the bad loans that helped fuel the bubble. If nothing else worked, it also could have used a policy of explicitly targeted interest rate hikes (i.e. it will raise interest rates until real house prices fall back to their 2000 level) to bring down house prices. It is difficult to imagine the Fed following a more disastrous policy than it actually pursued. There are a couple of other points in this piece that are not exactly correct. The recession caused by the stock bubble was relatively mild, but so was the recovery. The economy did not regain the jobs lost in the downturn until January of 2005 making it the longest period without job growth in the post-war era. Furthermore, it was only the growth driven by the housing bubble that provided the basis for a sustained expansion. The article also reports that the collapse of the stock bubble had less impact than the housing bubble because only 20 percent of the population holds stock, while close to 70 percent own a home. Actually, approximately half of the population owns stock, if mutual funds are included. However, most stock owners have a relatively small share of their wealth in the market. The median stock holding is around $25,000. By contrast, most people have the vast majority of their wealth tied up in their home. And, this wealth is typically highly leveraged which means that price declines can wipe out their holdings. For example, if someone had an 80 percent mortgage on a house worth $200k, then they had $40k in equity. If the house price fell by 20 percent, then they have lost all their equity. If fell by 30 percent then they are $20k underwater. This is the reason that the drop in house prices had so much more impact on consumption behavior. Finally, the chart in the article wrongly shows that there will some positive job growth in the decade. The Bureau of Labor Statistics benchmark revision to the jobs data will increase the number of jobs lost as of March 2009 by 824,000, pushing the figure for the decade into negative territory.
--Dean Baker