Cross-posted from Fortune
Earlier this month, the U.S. Federal Reserve chair acknowledged that prices for some social media and biotech stocks may be stretched.
Just over a decade ago, then U.S. Federal Reserve Board Chair Alan Greenspan told an adoring audience at the American Economic Association that the best way to deal with asset bubbles is to ignore them. Greenspan was relating what he considered to be his success with the 1990s stock bubble. Rather than trying to take steps to keep prices from moving higher before the bubble grew large enough to pose a danger to the economy, he and his colleagues at the Fed decided that the best option was to let it run its course and then pick up the pieces after the bubble burst.
Even back in 2004, there were good reasons to question the wisdom of this approach. The country was enduring what was at the time its longest stretch without net job growth since the Great Depression. This was the reason the Fed was holding the federal funds rate at the extraordinarily low rate of 1.0% more than two years after the 2001 recession had officially ended. But those of us who thought asset bubbles were something the Fed should concern itself with were just a tiny minority of the economics profession.
That changed with the collapse of the housing bubble in 2008. The financial crisis and Great Recession have convinced most economists, including those in top positions at the Fed, that asset bubbles must be taken seriously. This still leaves the question of how best to rein in bubbles.
There are two basic schools of thought. One of these schools believes that the Fed should directly use monetary policy to stem the growth of bubbles. This would mean raising interest rates to bring down asset prices.
While there is little doubt that higher interest rates will eventually quell the growth of a bubble, high interest rates will also slow the economy. In a situation like the present, where the economy needs all the support it can get, using interest rates to stem the growth of a bubble would mean a big loss of jobs output.
The other approach is the use of the Fed's regulatory powers and its ability to warn the public about the dangers of a bubble. In other words: talk. The use of regulatory authority is straightforward. The Fed can try to restrict the flows of credit that are spurring the growth of a bubble. For example in the case of the housing bubble, publishing mortgage guidelines that would have excluded the worst loans (which it did in the summer of 2008) might have prevented the proliferation of subprime lending.
The talk approach is also fairly simple. The Federal Reserve Board has an enormous megaphone. When the Fed chair testifies before Congress or gives a public address in another forum, the financial sector has to pay attention. If the Fed chair uses this platform to call attention to a bubble, it is likely to have an impact on investor behavior.
This is not a story of having the Fed chair mumble "irrational exuberance," while giving his or her subjective assessment on asset prices; it is about having the Fed warn of asset prices being out of line with the fundamentals of the market and historical experience, and presenting the evidence to back up this case.
This is exactly what Federal Reserve Board Chair Janet Yellen did in her congressional testimony earlier this month. She warned that the prices of some social media and biotech stocks appeared to be out of line with their earnings potential. She also noted that junk bonds seemed to be over-priced given their inherent riskiness. Her written statement included the evidence to back up these assertions.
No one expects that every investor and fund manager will dump their holdings of these assets based on Yellen's comments. However they will take the evidence she presents seriously. Any fund manager with a heavy stake in these assets will be looking for a new job if their price subsequently plunges. Unlike with the housing bubble, "who could have known?" will not be an acceptable excuse.
The evidence to date is that Yellen's warnings had the intended effect. The price of these assets has fallen considerably, although we will need a longer period of time to ensure that the effect is not temporary.
It is certainly encouraging to see Yellen experiment with this approach. It's good the Fed recognizes its need to prevent the excessive growth of asset bubbles, but it is also important that the Fed carry through this task in a way that doesn't itself cause serious economic damage. Providing information to financial markets is the lowest cost path imaginable to bubble containment. We should all hope that it works.