Are bubbles a preventable illness?

Throughout history ,financial crises often follow these asset price bubbles. The Fed ultimately has responsibility for maintaining the stability of the US economy, so should the central bank and government do more to prevent these bubbles from developing in the first place? In my previous post I outlined how I felt The Fed contributed to the housing bubble and I also touched on how political influence may make it difficult fopr The Fed to completely cut off any increase in asset prices. However I do believe that they could have acted differently in order to limit the boom in housing prices.

The first step (possibly the most simple and most important) would have been to acknowledge the existence of a bubble in the first place and at a much earlier stage. Working along with both the Federal Government and mortgage lenders they could have informed and educated the general population on the dangers associated with the bubble which was developing. They could have encouraged more caution on the part of both lenders and borrowers which may have somewhat curtailed the problem of irrational behaviour I discussed earlier.    

Secondly, as the regulator they could have issued specific regulations with regard to subprime lending. They could have specifically targeted the mortgage lending industry with increased standards which would have to have been met by borrowers. More specifically, dangerous products such as greater than 100 per cent mortgages could have been abolished and higher standards with regards to borrower suitability could have been introduced. Regulation could also have been used to influence the assets held by banks and their over all exposure to property backed assets could have been reduced.

Finally, and possibly the most extreme measure would have been to increase interest rates in an attempt to directly reduce mortgage borrowing. This step would have reduced to availability of funds to banks and therefore to individuals. This step however may also have had negative effects for the wider economy such as small businesses and therefore would have been unpopular with the Federal Government and the population.

On his blog (available here) Professor John Turner of Queens University Belfast recently posted a video of Adam Posen from the Monetary Policy Committee at The Bank of England discussing asset price bubbles. Mr Posen argues that it is not possible to tell the difference between a bull market and an asset price bubble before the bubble bursts and therefore central banks are not able to take pre-emptive action to deflate a bubble as this would damage real growth in the economy.

My own opinion at this stage is that for both practical and political reasons it can be difficult for central banks to prevent asset price bubbles, none the less, they should be extremely careful not to encourage bubbles to develop in the first place!