Economic meltdowns let them burn or stamp them out?

Economic meltdown: let it burn or punch out?

  • The Dutch tulip bulb mania of the 1600s, where rare tulip bulbs sold for many times the average person's annual income
  • The stock bubble of the British South Sea Company, where after exclusive trade granted rights with Spanish South America, speculators speculated in a frenzy buying the company's stock
  • The sports card price bubble of the 1980s and 1990s, where many kids (and adults) spent hard-earned pocket money to get rookie cards from unproven players
  • The dot-com bubble of the 1990s, in which investors were "irrationally exuberant" in drive technology, driving prices to unjustified levels.
  • The U.S. housing price bubble of the mid-2000s

In this article, we will use the politics of forest fire management as an analogy to discuss whether market forces should be allowed to pop speculative bubbles, clear the forest floor, and quickly return the market to a state of nature, or if governments and central banks should try to "light fires", to slowly deflate speculative bubbles that, if allowed to burst, could harm the entire economy. (To learn more about why speculative bubbles can happen, read How investors often cause market problems .)

The Forest Fire "Natural Burn" -Policy debate
According to the Environmental Literacy Council, "In the past, when fires started for natural or other reasons, efforts were made to control them as quickly as possible." This has changed somewhat as more has been learned about the role of fire in forest ecosystems: Forests where fires are regularly suppressed can burn much hotter and more dangerously when a fire finally does break out. the forest floor, certain tree species cannot regenerate (oaks and pines, for example, need fire to crack their seeds) and trees that do thrive become densely packed. Within this forest structure, the number of fires continues to increase, gains intensity. "

Similar to forest fires, some believe that when governments and/or central banks try to prevent or stop a speculative bubble from bursting, it only creates fuel for a bigger problem down the line. When the bubble finally bursts, the effect is more intense and does more damage to the overall economy.

Federal Reserve's fire-and-rescue unit
Some have accused the Federal Reserve of putting out too many fires, making asset price bubbles more expensive. Many believe this situation went hand in hand with housing prices in the 2000s. The following is from a Wall Street Journal interview with former Federal Reserve Chairman Alan Greenspan.(To read the story, see How the Federal Reserve was formed .)

The prevailing view among critics points Greenspan to two main counts:

  • First, he says, his Fed cut interest rates too much from 2001 to 2003 in an effort to decouple the economy from the bursting dot-com bubble. Then it took too long to raise them again. Low interest rates contributed to mortgage lending and drove home prices to unsustainable levels.
  • Second, they say, the Fed has been lax in its regulatory role. The Federal Reserve did not push for stricter mortgage underwriting rules against people who ultimately could not afford them. These critics also argue that the Fed failed to anticipate banks' exposure to high-risk homebuyers and left them with insufficient capital reserves to offset the eventual losses on those mortgages.

At the time, Greenspan expected his policies to spur housing construction, as the rest of the economy was relatively unresponsive to lower interest rates. Based on decades of his own research, he believed that a vibrant housing market would encourage consumers to borrow against home values and spend more. This would not create a housing bubble, he predicted, because it was difficult to speculate in homes, and memories of the stock market crashes of 2000 remained fresh.
Greenspan later admitted he was wrong about the unlikelihood of a housing bubble, but he had long maintained that bubbles were an inevitable 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 the belief of some foreign central bankers that their job is to defend against excessive asset inflation: "No sensible policy could have prevented the housing bubble."
Banks and lenders may place some blame on relaxed lending standards in the subprime mortgage market, but critics also blame the government. The combination of government intervention and loose lending by financial institutions led to an overheated market. Of course, it's easy to judge the story when you already know how things turned out. (For more on the subprime market, read Subprime Lending: Helping Hand or Underhanded? And Who's to Blame for the Subprime Crisis? )

The pros and cons of a" Natural Burn "Policy
In forest management, the term" refers to natural burning "on allowing smaller wildfires to occur on a regular basis to avoid larger, uncontrollable fires. The term can also apply to financial markets. Should the Fed allow small financial disasters to intervene little – a "natural fire" -Policy – or should they, in most cases, resist these problems? Let's look at some of the pros and cons of market forces to eliminate a price bubble. We use the housing bubble as an example.

Advantages of a natural burn policy:

  1. Prices find an efficient equilibrium in both the short and long term. No artificial demand is created that has the potential to burn. With intensity in the future.(Government intervention can only temporarily place people in housing they can't afford long-term.)
  2. There is less uncertainty about future prices, bringing both buyers and sellers back into the market and leading to rational risk taking. Rational risk-taking is critical to a strong, free-market economy. Capital must operate with the belief that a profit can be made. (Buyers are buying with confidence instead of a wait-and-see strategy. With a clearer picture of the future, banks are more willing to lend, which boosts housing activity. Builders have a better understanding of supply and demand and can be profitable.)
  3. A strong, healthy housing market emerges.

Disadvantages of a natural-burn policy:

  1. Financial disasters strike quickly. (Real families lose their homes.)
  2. Financial firms involved in mortgages are failing, adding more fuel to the fire.
  3. Problems in one part of the financial world create systemic financial risks and risks to the entire economy. (Home prices are falling fast. With low equity and negative consumer sentiment, consumer spending declines, creating the potential for a deep and widespread economic recession.)
  4. What hopefully will be a short-term flare-up in the housing market could burn uncontrollably throughout the economy.

Government and central bank intervention in the workings of a free market has been one of the great economic debates in history and will surely continue to be so. Market forces have a fast and efficient way to get to the bottom of problems, but such a "natural fire" -Politics could have secondary effects on the overall economy. The question of how and when a government or central bank can get into the "irrational exuberance" of the free market should intervene is controversial. Saving part of the economy from the bursting of any asset price bubble may make the entire economy more vulnerable 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 to deal with similar events as they occur in the future. Many lessons are learned from the housing price bubble.

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