Economic Meltdowns: Let Them Burn Or Stamp Them Out?

By Barry Nielsen AAA

Free markets are prone to speculative bubbles. Over the years, these have included:

  • The Dutch tulip bulb mania of the 1600s, where rare tulip bulbs sold for many times the average person's annual income
  • The British South Sea Company's stock bubble, where after being granted exclusive trading rights with Spanish South America, speculators went into a frenzy buying the company's shares
  • The sports card price bubble of the 1980s and 1990s, where many kids' (and adults') hard-earned allowances were spent buying up the rookie cards of unproven players
  • The dotcom bubble of the 1990s, where investors exhibited "irrational exuberance" in driving technology share prices to unjustified levels
  • The U.S.housing price bubble of the mid-2000s

In this article we'll use forest fire management policy as an analogy to discuss whether market forces should be allowed to burst speculative bubbles, "clean the forest floor," and quickly return the market to a natural state, or if governments and central banks should try to "put fires out" in an effort to slowly deflate speculative bubbles which, if allowed to burst, might harm the broader economy. (To read more on why speculative bubbles may arise in the first place, check out How Investors Often Cause The Market's Problems.)

The Forest Fire "Natural Burn" Policy Debate
According to the Environmental Literacy Council, "historically, when fires from natural or other causes began, efforts were made to control them as quickly as possible. That has changed somewhat as more has been learned about the role of fire within forest ecosystems. Forests in which fires are regularly suppressed can burn much hotter and more dangerously when a fire finally does break out. With suppression, large amounts of underbrush accumulate on the forest floor, certain tree species cannot regenerate (oak and pine, for example, need fire to crack their seeds), and trees that do flourish become densely packed. Within this forest structure, the number of fires continues to increase, getting larger and gaining in intensity."

Similar to forest fires, some believe that when governments and/or central banks attempt to forestall or prevent the popping of a speculative bubble, this only creates fuel for a bigger problem down the line. When the bubble finally does burst, the effect is more intense, and causes more damage to the broader economy.

The Federal Reserve Fire and Rescue Unit
Some have accused the U.S. Federal Reserve of putting out too many fires, adding fuel to asset pricing bubbles. Many believe this situation is what occurred with housing prices in the 2000s. The following comes from a Wall Street Journal interview with former chairman of the Federal Reserve, Alan Greenspan. (To read the history, see How The Federal Reserve Was Formed.)

The prevailing view among critics faults Greenspan on two main counts:

  • First, they say, his Fed lowered rates too much from 2001 to 2003 to cushion the economy from the bursting dotcom bubble. Then it took too long to raise them again. Low rates fueled mortgage borrowing, driving home prices to unsustainable heights.
  • Second, they say, the Fed was lax in its regulatory role. The central bank failed to press for stiffer rules for underwriting mortgages to people who ultimately couldn't afford them. These critics also argue that the Fed failed to anticipate banks' exposure to risky home buyers, leaving them with inadequate capital reserves to absorb the eventual losses on those mortgages.

At the time, Greenspan expected his policy to boost housing because the rest of the economy was relatively unresponsive to lower interest rates. Based on decades of his own research, he believed a buoyant housing market would spur consumers to borrow against home values and spend more. This would not produce a housing bubble, he predicted, because it was difficult to speculate in homes and the memory of the 2000 tech-stock bust remained fresh.

Greenspan later admitted that he was wrong about the improbability of a housing bubble, but he has long maintained that bubbles are an unavoidable feature of a dynamic economy. In a 1999 speech, he warned of recurring but unpredictable patterns of overconfidence followed by investor panic. He does not share some foreign central bankers' belief that their job is to defend against excessive asset-price inflation: "No sensible policy," he maintains, "could have prevented the housing bubble."


Banks and lenders can assume some of the blame due to relaxed lending standards in the subprime mortgage market, but critics also lay blame on the government
. The combination of government intervention and relaxed lending by financial institutions created an overheated market. Of course, it is easy to judge history when you already know how things have turned out. (For more on the subprime market, read Subprime Lending: Helping Hand Or Underhanded? and Who Is To Blame For The Subprime Crisis?)

The Pros and Cons of a "Natural Burn" Policy
In forest management, the term "natural burn" refers to allowing smaller forest fires to occur on a regular basis in order to prevent larger, uncontrollable fires. The term can also apply to financial markets. Should the Fed allow small financial catastrophes to proceed with little intervention - a "natural burn' policy - or should they defend against these problems on most occasions? Let's look at some of the pros and cons of allowing market forces to extinguish a pricing bubble. We'll use the housing bubble as an example.

Pros of a natural burn policy:

  1. Prices find an efficient equilibrium in both the short and long term. There is no artificial demand created, which has the potential to burn with intensity in the future. (Government intervention can only temporarily keep people in homes they cannot afford in the long run.)
  2. There is less uncertainty about future prices, which brings both buyers and sellers back into the market and leads to rational risk-taking. Rational risk-taking is vital to a strong, free-market economy. Capital must be put to work with the belief that a profit can be earned. (Buyers buy with confidence as opposed to a "wait-and-see" strategy. With a clearer picture of the future, banks are more willing to lend, spurring housing activity. Builders have a better understanding of supply and demand, and are able to operate profitably.)
  3. A strong, healthy housing market emerges.

Cons of a natural burn policy:

  1. Financial disaster quickly strikes some. (Real families lose their homes.)
  2. Financial firms with an exposure to mortgages fail, adding more fuel to the fire.
  3. The problems in one part of the financial world create systematic financial risks and risks to the broader economy. (Home prices drop quickly. With little equity extraction and negative consumer sentiment, consumer spending falls, creating the potential for a deep and far-reaching economic recession.)
  4. What was hoped to be a short-lived flare-up in the housing market could burn uncontrollably throughout the economy.

Conclusion
Intervention by governments and central banks in the workings of a free market has been one of history's great economic debates, and will certainly continue as such. Market forces have a quick and efficient way of getting to the bottom of problems, but such a "natural burn" policy might have secondary effects on the broader economy. The question of how and when a government or central bank should intervene in free market "irrational exuberance" is much debated. Saving parts of the economy from the popping of each asset price bubble can leave, and make, the entire economy more prone to larger and potentially more-damaging price bubbles - such as the housing price bubble. Economics is still not an exact science. With each crisis, we learn better how to deal with similar events as they arise in the future. Much will be learned from the housing price bubble.


For more information on this speculative bubble, see Why Housing Market Bubbles Pop.

comments powered by Disqus
Related Articles
  1. Human Capital, An Important Asset For ...
    Investing Basics

    Human Capital, An Important Asset For ...

  2. Hypothesis Testing in Finance: Concept ...
    Active Trading Fundamentals

    Hypothesis Testing in Finance: Concept ...

  3. Beware Of Wall Street's Three Big Lies
    Fundamental Analysis

    Beware Of Wall Street's Three Big Lies

  4. Become A Certified Financial Divorce ...
    Retirement

    Become A Certified Financial Divorce ...

  5. Finding Spin In The Financial Services ...
    Personal Finance

    Finding Spin In The Financial Services ...

Trading Center