IN the midst of the financial turmoil, it's easy to cast around for scapegoats. That was the reason why the $700bn bailout package failed to make it through Congress on Monday night - politicians found it difficult to use taxpayers' money to bail out Wall Street bankers who had behaved in an excessively risky manner.
Some politicians didn't want to be seen to be helping the scapegoats.
But when looking at scapegoats, one must necessarily go beyond the Wall Street bankers and look at the environment that created the conditions conducive to creating the biggest credit crisis since the Great Depression of the early 1930s.
The immediate cause of the crisis was the bubble in the US housing market. It seemed as if the US housing market would keep on rising forever, allowing banks to make loans to people who would usually not qualify.
Anyone who could see that the housing market was in a bubble could foretell what would happen. At some point, interest rates would rise to a level that the subprime borrowers couldn't afford, the housing bubble would burst and subprime borrowers would default on their debt. This happened, and the rest is history.
The key point here is that, in hindsight, it's clear that the US housing market was experiencing bubble conditions. But it's not just in hindsight; at the peak of the housing madness there were many voices that pointed out that this was a bubble. Bankers, however, chose to ignore the signs.
Easy money atmosphere
The question that arises is whether the central bank - the US Federal Reserve - shouldn't have seen the bubble developing and acted to prick it by raising interest rates. It has been argued in these pages that former Fed chairman Alan Greenspan helped create the bubble by slashing the Fed funds rate to 1% by June 2003 and keeping the rate at this level for a year.
Greenspan's actions created the easy money atmosphere in which US consumers felt free to pile on the debt. An important point is that US monetary policy didn't cause an inflationary effect. The effect was to create bubble conditions.
Greenspan has similarly been criticised for not pricking the dot-com boom of the late 1990s, when tech stock prices surged into the stratosphere. Most of these stocks had no earnings; instead of price-to-earnings ratios, investors were doing the unthinkable: Looking at price-to-revenue numbers.
Again, it didn't take rocket science to work out that this was a bubble. Many voices - including Greenspan's famous "irrational exuberance" comment in 1996 - went up about the situation. Yet the central bank did nothing really to prick the bubble gently with a hike in interest rates.
Make no mistake: the view that central banks should prick economic bubbles is a controversial one. While the view finds favour with populists - as is clear from the way in which Greenspan?s halo has slipped - it's not a view that central bankers and academics share.
Fed Governor Frederic Mishkin, in a speech on asset price bubbles earlier this year, argued that pre-emptive bubble-pricking rested on three assumptions, none of them likely to be met.
First, the central bank must be able to spot a bubble in the making. But that means that the central bank knows better than the market. Mishkin says the Fed doesn't know better than the market; if it knows for certain that a bubble has developed, then so will the market and the bubble will pop anyway.
Second, monetary policy must be unable to deal after the fact with the consequences of a bubble bursting for it to make sense to act pre-emptively.
Third, central banks must know the right monetary policy action to deflate a bubble ahead of time. That seems improbable, too. By definition, bubbles are abnormal times. The effects of an interest-rate rise in such times may be very difficult to predict. It might do more harm than good.
Mishkin has strong arguments, but they fail to convince me that central banks shouldn't be in the business of identifying bubbles.
But I agree that interest rates are a blunt instrument and there's no predicting how the market would react or what it would take to prick a bubble - without destroying economic growth in the process.
Undue faith
Perhaps the answer lies in better regulation. Financial Times columnist Martin Wolf, in answering the question as to what went wrong, writes: "A long period of rapid growth, low inflation, low interest rates and macroeconomic stability bred complacency and increased willingness to take risk. Stability led to instability. Undue faith in unregulated markets proved a snare."
The ability or inability of regulators to curb market excesses is a topic for another day. Suffice it to say that there are no easy public sector scapegoats, be it at the Fed or at the regulators, for the current mess.
- Fin24.com