Recommendations for a Bubble-Popping Fed

By Dr. Duru written for One-Twenty

May 21, 2008

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On May 16, 2008 the Wall Street Journal printed "Bernanke's Bubble Laboratory," describing how Ben Bernanke is pulling together a team of Ph.D.'s to study why bubbles form and how they can be prevented. For anyone who has paid attention to the markets, not one of the findings is surprising. And so far, there are no clear recommendations on prevention. This turn of events marks another twist in Greenspan's agony as Bernanke continues to turn his back on the legacy and fundamental tenets of Greenspan. Greenspan has long maintained that bubbles can only be identified after they have already burst, that the Fed is powerless to stop them and should not try, and that all the Fed can do is pick up the pieces after the bubble has popped. It was easy to say all this in a time when we still assumed that bubbles were rare occurrences and anomalies of human economic behavior that most impacted a small segment of insane speculators. But thanks to a lot of easy money by the world's central banks the past 15 years or so (especially in the U.S.), we have seen a series of cascading and pervasive bubbles. Bernanke is essentially now saying enough is enough. Time for some study... And it seems that Greenspan is still fighting to maintain his credibility on the subject of bubbles. Fast forward to May 20, 2008, and now we find Greenspan telling us that "...the recent rapid rise in world oil and food prices [is], in part, the result of a speculative bubble in international financial markets. Of course, he now has very little credibility to talk to us about bubbles. At least he reassured us that "inflation isn't out of control at this point." Nevermind that so many of the earnings report we have been hearing either focus on how a company is going to exercise pricing power and/or control increasing input costs.

Anyway, I will first present a summary of the bubblicious findings of Bernanke's team, and then I will give you my own recommendations on how to prevent bubbles (some tongue in cheek will of course be needed).

The Fed's findings...
  1. Financial bubbles are marked by huge increases in trading
  2. Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it
  3. Many big investors rarely short stocks. When differences between bullish investors and bearish ones are extreme, many of the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher.
Dilip Abreu and Markus Brunnermeier must have used game theory to find that "if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can't coordinate, it's risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble's existence becomes common knowledge." Ah yes, the magic of the crystal ball and perfect timing. Bubbles stretch specifically because everyone thinks they can play out the bubble to its peak and not a minute longer.

Since the Fed will not be hiring me anytime soon, I will use my own soap box to provide some sure-fire recommendations for preventing these bubbles from growing out of control...

Dr. Duru's Recommendations
  1. Issue an annual report that officially identifies bubble as determined by the Federal Reserve. Include target prices that more accurately reflect the fundamentals of the market
  2. Cut the capital gains tax for shorting in half
  3. Provide additional tax credits for institutions that short specific industries and sectors
  4. Create a bail-out fund for anyone or any institution that blows up trying to bet against a bubble
  5. Provide Federal Reserve lending facilities to increase the amount of leverage that can be exercised for shorting
Together, these measures would shift the balance of power away from the bubblists and toward the bubble-poppers. It will not be enough for the Fed to simply identify bubbles. The Fed will need to do something about it...besides raise interest rates on everybody. Greenspan found how powerless his words could be when he declared in 1996 that the markets were in the throes of "irrational exuberance." After large rate cuts to save the planet from the Asian financial crisis and then "Y2K", the technology bubble finally burst a whole 4 years later...which then encouraged the Fed (Greenspan) to drop rates all over again to use housing to save the economy. And on and on it goes...

As I finish writing this, the stock market appears to be in the middle of a small correction. Suddenly, oil prices matter and inflation expectations seem to be rising ever higher. Seems about time for some demand destruction from gasoline to stocks themselves. I still believe the advantage is in the bull's court, but headwinds are building anew. Consumers simply have nowhere else to turn for relief since the housing ATM is now closed and credit cards will only hold so much. If consumers turn to their bosses for raises, the labor market is soft enough for the company to reply with a firm "no." And if wage pressures do increase, I do believe the Fed will step in to try to stomp it out. The tax rebate checks will help for a short spell, but gas and food alone will suck up too much. During the last recession, consumers did not save and instead were goaded into spending more and more. When the economy recovered, the government chose not to save and instead spent more and more. Seems to me that there must be some limit to all this and some demand destruction may be the unfortunate cure.

Be careful out there...!

DR. DURU®, 2008