In recent decades, a series of policy missteps have laid the groundwork for the recurrence of financial bubbles and boom-bust cycles. The modern American economy is characterized by cycles that involve rapid inflation of asset prices (that often result in a surge in private sector borrowing and a temporary spike in aggregate demand), followed by an inevitable collapse of asset values, which in turn is followed by ultra-loose monetary policy for an extended period that lays the groundwork for a follow-on asset bubble and a new boom-bust cycle.
Some recent policy actions undertaken to alleviate the effects of the pandemic shock, though well-intentioned, are misdirected and may lay the foundation for a new boom-bust cycle. A few micro-bubbles have already emerged, and there is broader concern about elevated asset values and the growing temptation to “reach for yield.”
Though the modern era of boom-bust cycles may have originated in Japan in the 1980s, it truly took-off in the U.S. during the 1990s, with the initial public offering (IPO) of Netscape (there is some debate about the specific moment when the dot-com bubble emerged, but many consider Aug. 9, 1995, the day of Netscape’s IPO, as the start date of the dot-com mania). In a widely-noted speech in Dec.1996, then-Federal Reserve Chairman Alan Greenspan warned of “irrational exuberance” and observed that central bankers “should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy.”
But by early 2000s, both Greenspan and his eventual successor, Ben Bernanke, had concluded that identifying and pre-emptively deflating asset bubbles was beyond the scope of the Federal Reserve, and that the central bank would be wise to focus its attention on rapid action aimed at preventing a liquidity crisis from developing in the aftermath of a collapse in asset prices. This so-called “Greenspan Doctrine” emerged from the Federal Reserve’s experiences in dealing with the aftermath of the 1987 “Black Monday” stock market crash, the 1980s Savings and Loan (S&L) Crisis, the 1998 Long-Term Capital Management (LTCM) crisis and the 2000 collapse of the dot-com bubble.
Greenspan and colleagues were relatively sanguine about the potential economic impact arising from a collapse in asset values. They argued that bubbles were often the result of speculative overreaction among investors to the emergence of new technologies or financial innovations. Federal Reserve officials believed that, as long as the central bank acted aggressively to pump liquidity into the financial system and prevented a deflationary spiral, the economic impact of a collapse in asset prices was quite manageable. Though Greenspan and Bernanke felt assured in the early 2000s about their own approach to dealing with asset bubbles, they were unknowingly seeding the next asset bubble with their actions.
The misjudgment of the central bankers became apparent when the persistently low rates maintained by the Federal Reserve in the aftermath of the collapse of the dot-com bubble, along with the steadfast refusal to regulate or oversee the explosive growth in financial derivatives (such as mortgage-backed securities, collateralized debt obligations and credit default swaps), led to a massive housing bubble in the U.S.
Following the collapse of the housing bubble, the overleveraged U.S. financial sector came under tremendous pressure. The Federal Reserve engaged in unprecedented liquidity and credit easing measures to limit the fallout arising from the failure of Lehman Brothers. But once the risk to the U.S. financial system abated, the Federal Reserve decided to engage in controversial large-scale asset purchase programs that dramatically expanded its balance sheet. It also kept rates near zero for an extended period. The resultant spike in financial asset values again raised fears of a bubble.
The pandemic shock briefly halted the surge in U.S. equity prices in early 2020. However, the Federal Reserve, after once again acting as the savior of the tottering U.S. financial system, decided to redeploy its asset purchase program and promised to keep rates near zero for an extended period of time. Unsurprisingly, U.S. equity prices have surged to all-time highs in the aftermath, and the U.S. real estate market has now joined the party.
Risk-taking is a natural aspect of any capitalist society and should, within reasonable bounds, be encouraged. But misdirected policies can create the wrong incentives and generate moral hazard. The central bank’s penchant for turning a blind eye to surging asset prices and financial distortions while staying ever ready to step in and cleanup the damages caused by the collapse of asset bubbles has led many market participants to believe in the existence of a “Fed Put.” Besides giving rise to excessive risk-taking and capital misallocation, the boom-bust cycle associated with recent financial bubbles has also led to a widening of wealth and racial inequality.
Furthermore, Federal Reserve actions have let fiscal policymakers off the hook — when in power, Republicans offer unfunded tax cuts while Democrats engage in unfunded spending. Neither party feels the pressure to undertake difficult structural reforms.
An added risk in the current cycle is that surging asset prices combined with unprecedented fiscal and monetary largesse may finally cause inflation to emerge from its long dormancy. Standard inflation measures often fail to properly account for early signs of pricing pressures. By having overcommitted to its easy policy stance, the Federal Reserve will find it hard to change direction in the future without creating significant financial market upheaval.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.