Ben Bernanke Finally Hires an Asset Bubble Buster: Jeremy Stein

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Federal Reserve Governor Jeremy Stein (Getty Images)"What factors lead to overheating episodes in credit markets?"

This was one of the opening lines of a speech given Thursday at the Federal Reserve Bank of St. Louis by Jeremy Stein, a Federal Reserve Governor brought on board just last year. And his talk may mark a sea change in how the Federal Reserve thinks about, approaches, and responds to asset bubbles.

Live and Let Pop

Not long ago, the Federal Reserve didn't feel it had any business trying to deflate asset bubbles -- those weapons of mass financial destruction that can wipe an economy out almost overnight, like America's real-estate bubble did in 2008. And this was the policy from America's central bank, one of the country's primary financial overseers.

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In 2010, Fed Chairman Ben Bernanke himself told the Financial Crisis Inquiry Commission: "Monetary policy is a blunt tool. Raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy."

What that means in English is, even if the Fed spots, say, a housing bubble, it fears raising interest rates broadly (the only way to do it) because while raising interest rates would almost certainly deflate said bubble, it could also cool down other sectors of the economy that are humming along quite nicely in a safe, non-bubbly manner.

You Have to Start Somewhere

In his speech, Stein gave three factors he feels contribute to the overheating of credit markets, where asset booms are typically born:

1. Financial innovation, like the boom in complex investments such as derivatives and collateralized debt obligations that proved to be such ruinous contributors to the 2008 crash.

2. Changes in regulation, like we also saw in the lead-up to the crash, dating back decades, that allowed banks to take more and more risks until they were leveraged within inches of their financial lives.

3. Changes that alter "the risk-taking incentives of agents making credit decisions." Again, in English, this means if you pay, say, mortgage brokers to write subprime loans, they will do so without any regard for the eventual mayhem that might follow. Again, see the roaring 2000s.

All this still doesn't mean the Fed can or will step in to deflate or gently burst the next asset bubble (and there will be asset bubbles as long as there's capitalism). But you can tell that Stein gets it here. And for this potentially new direction in the Federal Reserve's thinking we can all be grateful. If nothing else, it's an encouraging start to a potentially less bubble-fraught future.
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