Preventing Bubbles: What Role for Financial Regulation?

November 15, 2011

It is now quite clear that the U.S. economy went through a massive housing bubble, starting in the late 1990s and lasting through mid-2006.  The inflating of that bubble was encouraged, to a considerable extent, by the expansion and especially the securitization of residential mortgage finance.  The housing bubble, in turn, reinforced that mortgage expansion and securitization.  The drastic consequences that the explosion of this bubble had on the American economy have caused many to call for public policy intervention to prevent future bubbles.  However, this would be unwise for a number of reasons.  Instead, policymakers should consider "prudent" regulatory actions that would mitigate the negative effects of bubbles, says Lawrence J. White, the Robert Kavesh Professor of Economics at New York University.

One of the difficulties in calling on decision-makers to prevent bubbles is that bubbles are not so easily identified in real-time.

  • While experts can pour over charts and data after the fact and assign specific dates and reasons to a given bubble, this analysis relies on information that is not present at the time.
  • Therefore, the prevention of bubbles would be foolhardy.

The call for intervention is not simply foolish, but dangerous to the efficient running of the market.

  • This is because potential bubbles can just as easily be an efficient allocation of financial resources to a certain asset whose true value is growing rapidly.
  • Were a federal institution to seek to address what it perceives to be a "bubble," it could just as easily be squelching an exceptional product.

Prudential regulation does not attempt to prevent bubbles so much as it attempts to mitigate their negative consequences by securing the solvency of banks.  Among them, prudence requires banks to hold minimum reserves to cover potential losses on risky investments.  Further, it restricts investment options whose value and risk are difficult to ascertain.  Additionally, it requires significant oversight in order to guarantee the competence of managers and prevent "looting" by the banks owners via excessive dividends.  Finally, all banks ought to have a receivership regime planned for potential insolvency.  By following these rules, bubbles may not be prevented but their effects can be limited.

Source: Lawrence J. White, "Preventing Bubbles: What Role for Financial Regulation?" Cato Journal, Fall 2011.

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