Now, if you noticed he didn't mention homeowners or consumers. Does this mean that it is the Fed's job to protect consumers from making mistakes or was he just trying to show that he isn't protecting large mortgage companies.

Now, rumors are flying that the Fed may cut rates in September as low as 50 basis points.  If the Fed is responsible for stabilizing the market, will it only act as needed after a crisis or will it act to divert a crisis?

It seems that in the case of the housing bubble, the Fed did nothing to prevent it. Obviously people make mistakes and act irrationally. We have seen this in stock market bubbles in the past and in local real estate bubbles. Also after the 911 terrorist attacks, the market dropped drastically.

Former Fed chairman, Alan Greenspan made a comment about "irrational exuberance" during the dot com boom era. He was talking about how stocks were going up for no apparent rational reason. After this comment, the stock market went down drastically.

This required no change in the federal funds rate and proved to be effective and letting people  know to stop fooling around.  The stock market eventually recovered but it at least showed a concern by the Fed.

Were any such warnings made leading up to this bubble? 

Real estate speculators bought homes at inflated prices for mostly two or three reasons, mortgage rates were at historic lows, home prices were moving up drastically, and the long standing belief that home prices cannot go down. 

The Fed could have done several things, produce a warning message similiar to the irrational exuberance remark from Alan Greenspan. It could have published a paper dispelling the rumors that houses cannot go down and could have shown that houses do in fact go down with all the statistics to prove it. Anything that the Fed does is widely covered by the media so this report could would be published by the news making it known to the public.

Lastly, it could have increased interest rates. This would most likely slow up the increase in prices, or possibly lead to a real quick last minute buyers increase in price. However after this initial jump, it would most likely get prices down and get the inevitable happening much sooner.

Stopping speculative behavior that is damaging to the economy should be stopped as soon as possible not after the fact.

However, with both Greenspan and Bernanke the policy is that bubbles are hard to predict and popping the bubble too soon may be worse that letting it go its own course. I think the reality of this is that both men want to keep their jobs as long as possible. It is within their self interest to let the bubble pop on its own then clean up the mess later.

Then there are many participants that can be blamed from the speculators themselves to the unscrupulous lenders to bad appraisers. However, stopping the bubble early and getting blood on your hands would make many people angry even though it is helping the economy over the long term. 

The best way to keep your position seems to be to avoid responsibilty on the matter entirely. When the threat of a crisis is building, deny that it exists as Bernanke did in a recent Washington Post article in Oct 2005, There's No Housing Bubble to Go Bust.

Then once the crisis happens, state that laws weren't in force to prevent this disaster or that it was out of the Fed's area of responsibility. A last resort is to state that bursting the bubble early would have been more damaging to the economy than to let it go out on its own.

In the case of Alan Greenspan, the former Fed chairman, he uses confusion to avoid responsibility. By using language that is hard to understand and wording sentences in such a way, nobody really understands what is being said. Eventually people just move on to something else because they have no idea what is being said.

However, sometimes things are said that shouldn't be said like the truth and being candid:

Economic Club of New York event, May 20, 2005:

Mr. GREENSPAN: Without calling the overall national issue a bubble, it's pretty clear that it's an unsustainable underlying pattern.

However, it was near the end of Greenspan's term so he can say whatever he wants without any fear because he will be out of the Fed soon and it will be someone else's problem.

In summary, here are some of the techniques used by the past two Fed chairmen to keep from having to take action against a growing asset bubble.

1. Don't admit that the problem exists
2. Use confusing data or wording to get others to stop asking questions
3. Admit that it is not the policy of the fed to prevent asset bubbles
4. Underestimate the threat and state that things should work themselves out
5. State that acting would make the bubble worse than it already is
6. Avoiding being too candid unless you are at the end of your term

Stay tuned for an upcoming article, Do we need the Fed? 

NYT Article (Subscription based) 

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