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A Bubble In Search of a Pin

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Should Greenspan, Bernanke, and the entire Fed have seen it coming?

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… The signals approach (or most alternative methods) will not pinpoint the exact date on which a bubble will burst or provide an obvious indication of the severity of the looming crisis. What this systematic exercise can deliver is valuable information as to whether an economy is showing one or more of the classic symptoms that emerge before a severe financial illness develops. The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often that not. That is why we also need to think about improving institutions.

… Second, policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial.


The evidence is there. So why did the Fed miss it?

A more pointed critique is leveled at the Fed and Greenspan, and at Bernanke in particular, by Andrew Smithers in his powerful book (now updated) Wall Street Revalued: Imperfect Markets and Inept Central Bankers. The foreword is by one of my favorite analysts, Jeremy Grantham. This is on the top of my reading list for the coming week. I'm loving the first part, which ties nicely into the themes explored by Reinhart and Rogoff.

The book is a withering critique of the Efficient Market Hypothesis (EMH), among other economic theories. Smithers argues that because the tenets of EMH are so ingrained, Greenspan and Bernanke couldn't recognize the bubble because they believed in the efficiency of markets. "Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of theory." Which they did.

As Grantham wrote in the foreword:

The evidence is there. So why did the Fed miss it?A more pointed critique is leveled at the Fed and Greenspan, and at Bernanke in particular, by Andrew Smithers in his powerful book (now updated) The foreword is by one of my favorite analysts, Jeremy Grantham. This is on the top of my reading list for the coming week. I'm loving the first part, which ties nicely into the themes explored by Reinhart and Rogoff.The book is a withering critique of the Efficient Market Hypothesis (EMH), among other economic theories. Smithers argues that because the tenets of EMH are so ingrained, Greenspan and Bernanke couldn't recognize the bubble because they believed in the efficiency of markets. "Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of theory." Which they did.As Grantham wrote in the foreword:

My own favorite illustration of their views was Bernanke's comment in late 2006 at the height of a 3-sigma (100-year) event in a US housing market that had no prior housing bubbles: "The US housing market merely reflects a strong US economy." He was surrounded by statisticians and yet could not see the data… His profound faith in market efficiency, and therefore a world where bubbles could not exist, made it impossible for him to see what was in front of his own eyes.


Reinhart and Rogoff show time and time again that bubbles always end in tears. Markets and investors are in fact irrational. What kind of Fed governor would it have taken to suggest that housing was in a bubble and we were going to have to take steps to slow it down -- raising rates, analyzing securitization and ratings? It would have taken one tough hombre. In fact, we had Greenspan, who encouraged the unchecked expansion of the securitized derivatives market, and a Congress that wouldn't allow proper supervision of Fannie (FNM) and Freddie (FRE) (which is going to cost US taxpayers on the order of $400 billion). The list is long.

No positions in stocks mentioned.

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