Should the Fed Intervene in Asset Bubbles - Thesis Example

Since hindsight offers perfect or a 20/20 vision, many people opined the US central bank failed in its task to promote healthy and sustainable economic growth for the country, and by extension being a multi-trillion dollar economy, for the entire world. The advent of a global economy has made potential economic disruptions like the bursting of asset bubbles a serious matter to contend with. Economists, politicians, and policymakers now pay more attention to the formation of asset bubbles, how these start, how these bubbles could be prevented from growing bigger, and what actions can be considered appropriate if a bubble is clearly identified.

It must be admitted that despite the experience of several prior asset bubbles, policy options are still woefully limited. Economists and academic theorists are conflicted on what responses are considered to be the most appropriate in such situations. The experience with asset bubbles is not fairly recent since the phenomena had existed since the middle Renaissance period. A frequently-used example was the so-called “tulip-mania” from 1634 up to 1637 in which a few special black tulips fetched the same price as a mansion!

Although there are many types of asset bubbles, there is some agreement that bubbles are formed by two causes: the first cause is when financial intermediaries like banks, brokers, brokerage houses, and even the central bank (by failing to act and are guilty by default) “pump” up the price of an asset or a particular asset class; the second cause is when a nation's financial institutions lend to people or groups who are politically connected. The US housing market is a good example of the first cause cited above in creating a bubble.

Banks, mortgage lenders, and mortgage brokers fed the frenzy by making obtaining a housing loan very easy, even to an extent of giving out mortgages to people who were imminently not qualified for a loan for the reason of not having adequate incomes to pay the monthly amortizations or even approving a loan to non-existent borrowers (bordering on outright fraud). The practice of American banks to originate and distribute (in contrast to other countries in which banks originate and hold) is seen as further hastening the expansion of the housing bubble.

Some experts blame complex financial instruments known as derivatives as the prick that finally caused the bursting of the housing bubble; in particular, they liked to cite collateralized debt obligations (CDOs) as the culprit. CDOs were and still are risky investment instruments; these represented an ill-defined asset class, namely derivatives similar to options (puts and calls) and credit default swaps. The second cause is when large sums of money are lent to people who are politically well connected in a form of financial cronyism.

Although not very prevalent in the US and in other Western economies, such practice is contributory to asset bubbles because it results in the misallocation of scarce financial resources better invested elsewhere. Good examples are the Korean chaebols and the Japanese zaibatsu which are the equivalents of classic American business conglomerates.