May 14, 2008 | posted by Michael Baxter in US economy |

You can’t lean against the wind – at least that’s been the wisdom in financial circles.

Famously Alan Greenspan once described the dotcom boom as irrational exuberance and he tried to talk shares down.  Then he appeared to have a road to Damascus moment, and decided that central banks could not possibly second guess markets. So, he chose instead to sit it out.

And he continued to sit it out when house prices shot up in the US.   

It was a policy Ben Bernanke agreed with and has long maintained that central banks can not be expected to monitor asset prices.

But of late the flak has risen to – well, bubble proportions.  Greenspan is being blamed for the financial crisis.  He let rates fall far too low, they say.  This enabled house price inflation, which is not leading to wider inflation.

Even his good friends at the IMF have joined the bandwagon – and recently said that maybe central banks should after all “lean against the wind.”

It is a complicated argument.  These days, the Bank of England monitors the CPI index, but even before that the index it targeted, the RPIX index, was inflation net of house price growth.

Some argue that it is just a case of changing the brief.  If central banks were told to target inflation over the longer-term, then presumably they would take into account factors that influence inflation in the longer-term, which would possibly mean house prices.

Instead, central bankers have to fret when inflation goes much above target.  In the UK, for example, the Bank of England is worrying about inflation going more than a full percentage point over 2 per cent.  This is why it has been reluctant to cut rates faster, even though many believe that once the current jumps in food and oil drop out of the annual equation, inflation will fall rapidly.

Now the Fed has dropped a hint it is changing its tune.   Apparently it is considering the possibility of using interest rates or using extra regulation to try and stop bubbles emerging in the future.

According to the FT: “Top officials are re-examining the Alan Greenspan doctrine that central banks should not try to tackle asset bubbles and should focus on mitigating the fallout when they burst.”

The trouble is, these ideas always come too late.  The aftermath of bursting bubbles are dangerous times.  That’s when regulators try to fix the mistakes they made in the past, and invariably go too far.  Sarbanes Oxley, for example, which was passed in the wake of the collapse of Enron and WorldCom, led to an exodus of firms listing on US stock exchanges. 

Bubble fighting is not a bad policy to adopt – but it can come unstuck.    AT&T emerged out of a bubble in laying telegraph wires across the US; Google was able to buy cheap server technology in the wake of the dotcom burst; it is a complicated world out there, and so often we find solutions create a new set of problems.