Bubble Watch

September 6, 2013

The global financial crisis destroyed over one-fifth of accumulated American wealth in just one year: 2008. That huge loss was on top of a far more modest but still significant 1.62 percent wealth loss in 2007. Both the U.S. stock market bubble burst in 2000 and the housing bubble implosion of 2008 contributed to the current situation, reinforcing the need for a Federal Reserve "bubble watch" program. If we could recognize patterns that lead to these bubbles, we could see them coming and adjust policy to protect wealth accumulation and the economy as a whole, says John H. Makin, a resident scholar at the American Enterprise Institute.

  • The 2008 housing bubble burst and the ensuing global financial crisis destroyed an unprecedented 22 percent of accumulated American wealth.
  • This massive destruction of wealth has resulted in a tepid recovery marked by below-average recovery levels of saving, consumption and investment.
  • The Federal Reserve needs to create a "bubble watch" program to prevent speculative bubbles from destroying wealth accumulation in the future.

However, the two major avenues of American wealth accumulation, financial assets and owner-occupied housing, have been both a help and harm to American households over the last half century.

  • The unique convenience of wealth accumulation through homeownership became so compelling after the equity bubble burst in 2000 that the housing bubble developed with considerable government encouragement from tax preferences during the decade after 2000.
  • The bursting of the stock bubble early in 2000 left American households searching for another avenue of wealth accumulation, and with considerable encouragement from banks and brokers, Americans households turned to real estate to accumulate wealth.

As history has shown, the financial asset and housing approaches to wealth accumulation have their drawbacks, particularly manifest in bubbles that, upon bursting, have set wealth accumulation back a long way. Policymakers' sensitivity to financial and housing markets and their desire to support those avenues of wealth accumulation have probably contributed to the bubbles in both sectors during the last half century. It may be better to allow the pace of wealth accumulation in those sectors to slow somewhat to avoid the disruptions that inevitably accompany the bursting of such bubbles.

In any case, the Fed needs to pay more attention to the tricky problem of identifying speculative bubbles before they burst. Any prospective Fed chairman needs to step up to the challenge of creating a viable Fed bubble watch program.

Source: John H. Makin, "The Global Financial Crisis and American Wealth Accumulation: The Fed Needs a Bubble Watch," American Enterprise Institute, August 29, 2013.

 

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