Policymakers often notice bubbles while they are happening. Greenspan famously voiced his worries about “irrational exuberance” in the stock market in December 1996, over 3 years before the dotcom bubble finally burst.
However, policymakers are usually unwilling to discuss bubbles or take actions to stop them. This article attempts to explore the reasons why.
1. If they point out that the stock market is in a bubble, they might get lots of vile from Wall Street and the financial world, including claims that they are trying to “sabotage the retirement savings of Mom and Pop investors”, which is definitely not appealing.
2. If their words or actions negatively affect the stock market, they could become scapegoats for the end of the prosperity. Most legislators/regulators are usually eager to avoid trouble, and questioning if the market is too high or not is courting trouble.
3. If a financial policymaker gives an opinion that the stock market is overvalued and the stock market continues to head higher for a lengthy period of time, he may lose a bit of respect and reverence among financial circles. Greenspan is still remembered for his irrational exuberance comment.
4. Taking actions against bubbles is often difficult. On one hand, if the central bank jacks up interest rates ten percent overnight, it could probably end the bubble. But it would also adversely impact the real economy. And although financial bubbles are a misallocation of capital, they are not necessarily without redeeming features.
The capital that went to railroads in the late 1800s paved the way for America’s industrial expansion (albeit many investors were left holding an empty sack). Similarly despite the bankruptcy of Global Crossing and other optic fiber companies, the fiber they laid underseas played a part in pushing forward globalization.
5. Half-hearted attempts at checking the bubble may actually end up fueling market expectations for a rise. Breaking this down, if a bubble is forming in the stock market and the Fed raises interest rates by 50 basis points, the market may stagger for a few weeks. Then it makes a new high, confirming the opinions of speculators and investors that the game is still on which would fuel a further rise in the stock market, aggravating the original bubble problem.
6. Finally, the financial industry fights tooth and nail against regulation it considers harmful to industry prospects. It’s ironic considering that Citigroup (C) lobbied hard in order to complete its merger in 1998 (which was initially against the regulations), only to find out the merger didn’t bring any substantial benefits. Introducing measures against a financial bubble that may harm the prospects of financial companies (which depend mostly on activity) would be faced with strong pressure from lobbyists, lawmakers etc.
Ironically, it may be a good time to buy stocks during a bull market when lawmakers are publicly very worried about stock prices. This occurred in the 1950s when congressmen held testimonials concerning whether the stock market was too high. Memories of the Great Depression were still vivid, and the Dow was approaching former Great Depression levels, causing people to worry whether a crash was imminent. Curiously the bull market in stocks mostly continued till circa 1970.
When we’re finally out of the current recession, we may find that lawmakers express worry when the Dow/S&P reaches its former highs. You’ll know what to do then!
This was a guest post by StockTradingToGo Community member Allen. Other recent posts from this author:
- 7 Key Reasons Why Bubbles Form
- Four Must Avoid Investment for New Investors
- Three Big Reasons to Buy Gold
- Comparing Japan’s Lost Decade to the Current US Recession
- 4 Great Gold Myths Debunked