Preventing bubbles: what role for financial regulation?

• Author: White, Lawrence J.
• Position: Report

It is now quite clear that the U.S. economy went through a massive housing bubble, starting in the late 1990s and lasting through mid 2006. The inflating of that bubble was encouraged, to a considerable extent, by the expansion and especially the securitization of residential mortgage finance. The housing bubble, in turn, reinforced that mortgage expansion and securitization.

The deflating of the housing bubble has had severe negative consequences: first, for the U.S. financial sector (which had both created and invested in the mortgage securitization instruments) and, subsequently, for the overall U.S. economy. Given these severe consequences, it is surely no surprise that there have been calls for policymakers to prevent future asset price bubbles-through the better exercise of monetary policy and financial regulatory policy.

This article focuses on financial regulation and argues that the use of financial regulation to try to prevent bubbles is a mistake--a fool's errand. Bubbles are easy to identify after the fact but much harder (or impossible) to identify beforehand. In the absence of (the near impossible) success in correctly identifying bubbles beforehand, efforts to address bubbles beforehand run the severe risk of squelching efficient and productive price changes the false positives--as well as squelching the speculative and ultimately wasteful price changes of a bubble. However, what financial

regulation--specifically, prudential regulation---can do is to ameliorate the consequences of a bursting bubble for the financial sector. (1)

The article is organized along the following lines: I begin by discussing bubbles and why efforts to try to address them directly through financial regulation (or, indeed, through any public policy) are unwise. Next, I contrast the consequences of the bursting of two recent bubbles--the U.S. tech stock market bubble of the late 1990s and the housing bubble of the 2000s--and argue that the latter's bursting was far more devastating because too many of the consequences fell directly on the thinly capitalized, highly leveraged financial sector that could ill afford the losses that the bursting created. Finally, I turn to the case for prudential regulation of financial institutions and then offer a brief conclusion.

Bubbles

After the fact, bubbles are always easy to identify: For a specific asset class, asset prices went up; subsequently they went back down. Therefore, this asset class experienced a bubble.

The U.S. housing bubble of the 2000s is only the most recent asset bubble. (2) Earlier bubbles of the past few decades include the U.S. tech stock market bubble of the late 1990s, the Japanese real estate and stock market bubbles of the 1980s, and the gold market bubble of the 1970s.

Of course, the history of asset bubbles' expanding and collapsing stretches far longer. That history encompasses the U.S. stock market expansion of the 1920s and subsequent collapse in the early 1930s, Florida land speculation of the 1920s, periodic U.S. railroad speculative bubbles of the late 19th century, the French (John Law) Mississippi land and British South Sea bubbles of the early 18th century, and the Dutch tulip mania bubble of the early 17th century. Economic and financial historians could surely expand considerably upon this list. (3)

However, the definitive identification of a bubble is always an after-the-fact event. During the period of the asset price increase, there will always be a diversity of opinion, including skeptics as well as enthusiasts after all, someone must be selling at the time that the enthusiasts are buying--but during the period of the price increase the sentiment of the enthusiasts outweighs that of the skeptics. But this is no different from a period of an asset price increase that is based on what afterward turns out to be a solid foundation for example, the rise in importance of the telegraph in the middle of the 19th century, the rise of the importance of the telephone in the late 19th and early 20th centuries, the rise of the automobile in the first half of the 20th century, the rise of radio broadcasting in the early 20th century, and the rise of television broadcasting in the middle of the 20th century, Enthusiasts promoted these trends; skeptics expressed doubt.

In each of these instances there will be asset price rises that are associated with these trends whether it is the share prices of the companies that are at the center of these trends or land prices of geographic areas that are proximate to these trends. Any beforehand attention to these bubbles by public policy--in essence, paying greater attention to the skeptics--would risk squelching efficient allocations of resources. Further, in some instances there may be a longer-run expansion and then deflation of the asset prices (e.g., General Motors stock or Detroit land prices). Should these types of longer-run asset price inflations and subsequent deflations also be included as bubbles that warrant public policy attention?

As this brief review highlights, any discussion about bubbles is really a discussion about the efficiency of financial markets. Again, after the fact, it is easy to identify bubbles and thereby to conclude that the financial markets had been mistaken during the period of the asset price run-up. However, it is a large leap from this after-the-fact conclusion to a real-time determination that the financial markets are currently mistaken in the valuation of a specific category of asset. The proper action for anyone who has this belief is to find an opportunity to sell the asset short--not to try to convince policymakers that intervention is warranted.

Further, it is an equally large leap from the after-the-fact conclusions that there have been asset bubbles to the public policy determination that financial markets are generally inefficient and therefore warrant widespread intervention to ward off asset bubbles (as well as other ills of inefficient markets). To make this leap would mean that policymakers should be giving excessive weight--more than the financial markets give--to the skeptics (bears); and it is far from clear why policymakers should have superior knowledge as compared to the collective sentiment of the financial markets at such times. Instead, the proper action for policymakers is to focus on areas where market failures are large and pervasive (and are not likely to be swamped by the problems of government failures) rather than heeding the skeptics and those who believe that the financial markets are pervasively inefficient. (4)

Different Consequences from Different Asset Bubble Deflations

To express skepticism about public policy's ability accurately to spot asset bubbles in advance, is not to deny that there can be serious consequences from the eventual deflation of an asset bubble. The severity of those consequences can be related to the extent of the involvement of crucial parts of the financial sector. A comparison of the consequences of the deflating of the tech bubble of the late 1990s and the deflating of the housing bubble of the 2000s illustrates this differential severity.

The Bursting of the Tech Bubble

Between year-end 1999 and year-end 2002, the bursting of the tech bubble of the late 1990s led to approximately $7 trillion in aggregate U.S. stock market losses. (5) This massive loss of wealth had serious consequences for the U.S. economy. The economy slowed and entered a recession in March 2001, hitting a trough in November 2001. The unemployment rate rose from 3.9 percent in October 2000 and peaked at 6.3 percent in June 2003.

However, the recession was considered to be relatively shallow by recent standards. In essence, the loss of wealth was absorbed, the economy slowed and dipped, and then the economy moved on.

The Bursting of the Housing Bubble

According to the Case-Shiller index of residential housing prices, U.S. housing prices hit a peak in June 2006. At the time, U.S. single-family housing in aggregate was valued at approximately $19.4 trillion. (6) As of this...