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 AssetBubblesandTheirConsequences
by Gerald P. O’Driscoll Jr.
Gerald P. O’Driscoll Jr., senior fellow at the Cato Institute, was formerly vice president and economic advisor at the Federal  Reserve Bank of Dallas.
No. 103
Inthepast,thefederalgovernmenthasintro-duced moral hazard in the banking systemthrough deposit insurance. Banks underpricedriskbecauseofthefederalguaranteethatbackeddeposits. After banking crises in the 1980s and1990s, deposit insurance was put on a soundbasis and that source of moral hazard was miti-gated. In its place, monetary policy has becomea source of moral hazard. In acting to counterthe economic effects of declining asset prices,the Federal Reserve has come to be viewed asunderwriting risky investments. Policy pro-nouncements by senior Fed officials have rein-forced that perception. These actions and pro-nouncements are mutually reinforcing anddestructive to the operation of financial mar-kets. The current financial crisis began in thesubprime housing market and then spreadthroughout credit markets. The new Fed policy fueled the housing boom. Refusing to acceptresponsibility for the housing bubble, the Fed’srecentactionswilllikelyfuelanewassetbubble.The cumulative effects of recent monetary poli-cy undermine the case for free markets.
May 20, 2008
Executive Summary
Cato Institute•1000 Massachusetts Avenue, N.W.•Washington, D.C. 20001•(202) 842-0200
 
Introduction
“The Fed . . . is unwittingly contribut-ing to a form of moral hazard—that itstands by ready to prop up the marketif it fails, but will do nothing to stop itgoing up too high.”
1
In recent years, investors have rationally come to believe that the Federal Reserve willintervene to prevent or offset the effects of declining asset prices. That belief was firstsummarized in the phrase “the GreenspanPut,” now the “Bernanke Put.” The currentfinancial crisis is at least partly the outcomeof this new approach to monetary policy.Sincethe1930sthefederalgovernmenthasinsuredbankdeposits.Thatschemeinherent-ly reduced the vigilance of bank depositorstoward their banks, removing constraints onrisk taking by the insured depository institu-tions.Thesituationbecameacuteinthe1980sand 1990s, when undeterred risk taking by banks and thrift institutions led to a series of financial crises. Eventually the deposit insur-ancesystemwasreformedandbankingputona sounder basis. It is time for a similar reformofmonetarypolicy.
TheSubprimeMortgageCrisis
The popular press discovered subprimemortgageloanswhentwomajororiginatorsof such loans, HSBC Holdings PLC and New CenturyFinancial,disclosedincreasedloanlossprovisions.HSBCisagloballydiversifiedfinan-cialcompanyandsurvivedthecrisisintact.New CenturyFinancialfaredmuchlesswellbecauseoftheconcentrationofitslendinginthisrisky category. Its stock price collapsed after prob-lems surfaced on February 8, 2007, and thecompanyeventuallydeclaredbankruptcy.
2
Problems spread to other lenders in thesubprime market. By the end of 2007, morethan 100 mortgage companies had suspend-ed operations or sought buyers. The spreadbetweeninterestratesonsubprimeloansandthose on safe treasury securities increaseddramatically, indicating rising risk aversionto that market.
3
The carnage continued into 2008 andeventually claimed investment house BearStearns, bailed out by JP Morgan Chase withassistance from the Fed and U.S. Treasury.The U.S. economy experienced a seriousslowdown, as measured by the anemic annu-alizedgrowthrateforrealGDPof0.6percentinthefourthquarterof2007.Thatweakrateof growth was repeated in the first quarter.Technically, the economy did not fall intorecession.Theseedsofthesubprimecrisisweresownyears earlier, and the collapse in that submar-ket of mortgage lending is linked to previousfinancialeruptions,suchasthehigh-techandtelecombust.Thesubprimecollapsespreadtoother segments of housing finance. The crisisin housing finance in turn spread to othercreditmarkets,eventointerbanklending.Thefinancialcrisisisthelatestinaseriesoffinan-cialbubbleswhoseexistencereflects,atleastinpart,moralhazardinfinancialmarkets.Moralhazardistheoutcomeofexplicitorimplicit guarantees to investors. At one time,depositinsurancewasamajorculprit.Today,monetary policy is fostering moral hazard.Monetarypolicycangeneratemoralhazardif it is conducted in a manner that bails in- vestors out of risky and otherwise ill-advisedfinancial commitments. If investors come toexpect that the policy will persist, then they will deliberately take on additional risk with-out demanding commensurately higherreturns for that risk. In effect, they will lendat the risk-free interest rate on risky projects,or at least at a lower rate than would other-wisebethecase.Toomuchriskylendingandinvestment will take place. Capital will havebeen misallocated.
MonetaryPolicy 
Tosimplifyacomplextheoreticalissue,anideal monetary policy is one that facilitates
2
Monetary policy can generatemoral hazard if itis conducted in amanner that bailsinvestors outof risky andotherwise ill-advised financialcommitments.
 
and does not distort economic decisionmak-ing. In a market economy, the key decisionsinvolve allocating resources to their most valuableuse.
4
Marketpricesplayacriticalrolein that process by signaling to everyone therelativescarcityofgoodsandurgencyofends.Friedrich A. Hayek characterized the pricesystem as a communications mechanism fortransmittinginformationabouteconomicval-ues.
5
By communicating that valuable infor-mation,thepricesystemhelpscoordinateeco-nomic activities. As with any communicationsystem,itisdesirabletofilterout“noise,”extra-neous signals that interfere with communica-tion. Money is indispensable to price forma-tion,butmoneycangeneratenoisealongwithinformation. The
ideal 
monetary policy is onein which there is no noise, only valid price sig-nals. The
best possible
monetary policy wouldmaximizethesignal-to-noiseratio.
6
Monetary noise comes about when policy changesthevalueofmoney.Ineconomiesongold or silver standards, the discovery of new sources of the precious metal could set inmotion forces leading to an expansion of themoney supply and the depreciation in the value of money. In modern times money iscreated by printing it or through expansionof the liabilities of banks. In nearly all devel-oped countries, the rate of that expansion is(or can be) controlled by central banks.
7
Changesinthevalueofmoneycreatemon-etary noise because investors and ordinary individuals mistake changes in money pricesfor changes in relative prices. For instance,during inflation prices rise just to reflect theincreaseinmoneyandnotastheresultofany shiftinpreferencesforgoods.
8
The best possible monetary policy wouldseem to be one in which no change occurredin the value of the appropriate price index.Thetheorysupportingapolicyofzeroorlow price inflation is conventionally termed“monetarist” and its modern origins go backto Milton Friedman.
9
 A number of central banks, such as theBank of England and the European CentralBank have adopted inflation targeting asofficial policy. The Fed has not done so offi-cially. But it has heretofore behaved as if ithas an inflation target, and markets believedthat to be so. The Fed is widely believed towant inflation to remain under 2 percent—low but not zero.
10
CPIinflationhasremainedabovetheFed’snotional target for some time. In February 2008, the consumer price index for all urbanconsumers (CPI-U) was 4 percent higher thaninFebruary2007.Toputthatfigureinhistor-ical context, President Richard M. Nixondecided to impose comprehensive price andwagecontrolsonAugust15,1971,becausetheCPI seemed stuck at 4 percent inflation orhigherallthatyear(havingactuallyhita5per-centannualratetheprioryear).Certainly Nixon chose the wrong remedy,buthisintuitionthat4percentinflationwasunacceptably high was on target. Yet why aremost policymakers—as opposed to the pub-lic—now comfortable with that inflationrate? What has changed? Actually nothing has changed for thosewho earn, spend, and save dollars. What haschanged is that Fed officials prefer an infla-tionmeasureexcludingfoodandenergy(“coreinflation”).
11
They have persuaded most pub-lic officials, but not the public, of the wisdomof that approach. It is an increasingly unper-suasivelineofargument.TheFedoriginallydecidedtoexcludeener-gypricesbecauseitfeltitwasunreasonabletooffset OPEC-induced supply shocks. The Fedwanted an inflation measure that focused onpersistent movements. It did not want to beforced to offset one-time changes in the pricelevel, focusing instead on inflation targeting.By similar logic, the Fed thought it wise toexclude food prices so as not to take on theresponsibility of offsetting one-time changesinfoodpricesduetoweathershocks.Whatever the original merits of the Fed’sapproach,theglobalizationoffoodtrademit-igates the effects of localized weather eventson food prices. And rising energy prices aresystematicallydemand-drivenoutcomes.Coreinflation has become a misleading statistic,which disconnects policymakers from theexperienceofthepublic.
3
An idealmonetary policy is one thatfacilitates anddoes not distorteconomicdecisionmaking.
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