“Asset prices are a symptom. The underlying problem is excess credit growth.”

Can Central Banks stop bubbles? On Bloomberg, here's Caroline Baum:

"Dec. 11 (Bloomberg) -- Central banks care about financial stability.

Asset bubbles can be financially destabilizing.

Therefore, central banks care about asset bubbles.

If only policy makers found this syllogism persuasive.

Until now, central bankers pretty much cared about asset bubbles only to the extent that asset prices affected their ability to deliver price stability and, in the case of the Federal Reserve’s dual mandate, maximum employment. Otherwise, the operative doctrine was laissez-faire-’til-after-they-burst.

That’s about to change, said William White, who recently retired from the Bank for International Settlements, where he was economic adviser and head of the Monetary and Economic Department from 1995 to June 2008.

“The most calamitous downturns were not preceded by any degree of inflation,” White said in a telephone interview yesterday. “There was no inflation in 1873-74, in the 1920s, in the 1980s in Japan and in the 1990s in Southeast Asia.”

All these extended credit cycles ended badly. The U.S. economy contracted for 65 months, a record, from 1873 to 1879.

The bursting of the housing bubble and the deepening financial and economic crisis should be sobering to those who resist the idea that asset bubbles, when they burst, can be as destabilizing as inflation, which is the reason central bankers adopted inflation targets."

This is a pretty straightforward plan. Since Bubbles need easy credit or low interest rates for an extended period of time, don't let that happen. Central Banks can stop this by raising interest rates preventively.

"Central banks are still holding the line, at least publicly, on the inappropriateness of “targeting” asset prices, which misrepresents the issue. (More on that later.) Federal Reserve Vice Chairman Don Kohn said in a speech last month that he had reexamined the evidence and had came to the conclusion that he agrees with Alan Greenspan, his former boss and long-time advocate of bubble mop-up.

Bank of England policy makers are equally dug in, with Andrew Sentance, Charlie Bean and Sir John Gieve all arguing in recent speeches that using monetary policy, or interest rates, to “lean against the wind” is inadequate or inappropriate.

All these arguments miss the point. No one is suggesting central bankers target asset prices (Dow 13,000?). Nor is the issue bubble detection or identification, which implies policy makers know the appropriate level for asset prices and inspires visions of Sherlock Holmes-like characters looking under rocks in the hopes of making a discovery.

Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations."

I was going to argue that this plan was a Mechanistic Plan, when she surprised me by agreeing with me about such models.

"Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now. So why is it so hard for policy makers to grasp what White and his BIS colleagues have been saying for a decade?

“Targeting asset prices is not at all what we’ve been suggesting,” White said. “Asset prices are a symptom. The underlying problem is excess credit growth.”

Too much effort goes into differentiating this asset bubble from the rest: what White calls “the school of what’s different: the CDOs, CDO-squareds, the SIVs, the rating agencies.”

It makes more sense to focus on “the school of what’s the same, and that’s the credit cycle. There’s always something new, but there’s always something the same: leverage, speculation, declining credit standards,” he said."

He says that the problems are:

1) Leverage ( True )

2) Speculation ( True, but less important than 1 and 3 )

3) Declining Credit Standards ( True )

I would add:

4) Fraud, etc.

5) Government Incompetence

I also agree that it's not the new products, but disagree strongly about the Credit Ratings Agencies.

"Cracks are starting to appear in the asset-bubble-resistance facade. Questioned about a change in approach at an Oct. 15 speech, Fed chief Ben Bernanke said policy makers would have “to look very hard at that issue and what can be done about it.” He said it was unclear whether monetary policy or regulation and supervision was the proper tool.

Until now, there has been a persuasive argument for a hands- off approach to asset bubbles.

“Is it possible to lean against the upturn, or is it preferable to wait and clean up afterwards?” White said. “The models say you can wait. And it always worked. That’s a pretty powerful argument.”

The counter argument is that models aren’t always reliable. What worked in the past may not work now.

If the recession proves to be longer, deeper and more intractable than recent slumps, central bankers may come to appreciate the merits of leaning versus cleaning. Leaning may entail both “macroprudential instruments,” such as raising reserve requirements, capital requirements and loan-to-value ratios, and a “monetary instrument,” White said."

So, he suggests:

1) Raising Reserve Requirements ( Fine )

2) Raising Capital Requirements ( Fine )

3) Raising Loan-to-Value Requirements ( Fine )

4 ) A Monetary Instrument ( Not Sure )

"Cleaning appeared to have worked in the past, following the 1987 stock market crash, the early 1990s recovery from the savings and loan crisis in the U.S., and the late 1990s Asian financial crisis and near-collapse of Long-Term Capital Management. But “it works at the expense of making it worse next time around,” White said.

Cleansing, not cleaning, is what’s really needed. Without it, central banks have to “use a monetary instrument that is ever more aggressive” and will eventually cease to work, he said.

The best medicine, as with most things, may be an ounce of prevention.

“When you see a combination of rapid credit growth, a rapid rise in asset prices across a broad spectrum and changes in spending behavior, it should be a wake-up call that says: We have a problem,” White said.

Central bankers should realize that a lack of action during the credit upswing may impose greater costs to society.

“The facts are so obvious,” White said. “You don’t need to be a rocket scientist. Even an economist, when he sees something happen, will admit it is possible.”

If we see:

1) Rapid Credit Growth

2) Rapid Growth In Asset Prices

3) Changes In Spending Behavior

We should be worried.

I agree, but still find that using interest rates might be very harmful to businesses not participating in this rise, and a very blunt instrument. However, as a marginal tool, I wouldn't have a problem with it. But he conveniently left out the details of what he's calling for. I'm assuming that the blunt instrument argument is blunted by the bubble problem being a general problem, and so not limited to certain sectors, and pointing out that the bursting of the bubble has consequences for the entire economy.

It still seems to me that we need a better handle on how this mechanism actually influences people's behavior before we really commit to it.