Tags: greenspan | bubbles | normal

Greenspan: Bubbles Normal in the Economy

Thursday, 29 May 2008 04:51 PM

Former Fed chief Alan Greenspan says the central bank and other policymakers should accept bubbles as the companion of healthy economic activity.

But, he says, the government should make banks hold more capital in good times than in bad to insure that bursting bubbles don’t bury the financial system.

Bubbles represent almost a natural outgrowth of a vigorous economy, Greenspan told the Financial Times in a recent interview.

“If we want rapid growth in productivity, innovation, standards of living, we may have to accept that there will be periods of turmoil,” he says.

Of course his advice is a tad self-serving. Many criticize Greenspan for the Fed’s loose policy of the 1990s and first half of this decade, and allege easy money helped spark the tech stock bubbles and the later real estate bubble.

Current Fed Chairman Ben Bernanke and his colleagues are reconsidering the “Greenspan doctrine” that the central bank shouldn’t worry so much about bubbles and instead should focus on containing the damage once they burst.

Greenspan told the FT that he doesn’t oppose considering changes but, he warned, it won’t be easy for the Fed to adopt a different mode of operation.

That’s because bubbles don’t stem from isolated breakdowns in the markets but rather from the natural human emotions of greed and fear.

That fact is what makes it difficult to discern when bubbles form. “Is there a bubble today in food, energy, gold, currencies?” Greenspan asks. “If so, what specifically should we do about it?”

He says he is fully supportive of “leaning against the wind” with interest rate hikes when asset prices are rising rapidly, if a credible system for determining when to do so could be developed.

“I have just not seen any evidence that is feasible,” Greenspan says.

While he says he has “no doubt that we can very effectively quash a bubble,” the costs can be significant.

“What price do you pay in terms of suppressed economic activity?” Greenspan asks.

“There were no bubbles in the Soviet Union. Micro-meddling undermines the basic function of a financial system – that is, to direct the savings of society toward its most productive capital investments.”

Greenspan expresses skepticism about the Treasury Department’s proposal to charge the Fed with altering market behavior it thinks poses a risk to financial stability.

Financial crises “of necessity are unanticipated. If they are not, they are arbitraged away,” he says.

“We have many international financial stability forums, and none of them anticipated the problems of Aug. 9, 2007,” when the latest, real-estate driven bubble in financial markets first appeared.

What the Fed can do is “increase the capacity of our financial institutions to absorb shocks in general,” Greenspan says. “That means more capital.”

The credit crisis already has led the market to insist that financial institutions hold more capital now. The trick is to require banks to hold more capital when the economy and markets are booming, Greenspan says.

“I have always been in favor of counter-cyclical capital requirements,” he says. “There are virtually no bad loans made at the bottom of the cycle. The bad loans are all made at the top.”

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Former Fed chief Alan Greenspan says the central bank and other policymakers should accept bubbles as the companion of healthy economic activity.But, he says, the government should make banks hold more capital in good times than in bad to insure that bursting bubbles don’t...
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Thursday, 29 May 2008 04:51 PM
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