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This Economy: Shift at Fed: It'll examine bubbles and their bursts

Would we be better off if all speculative economic bubbles were eliminated? James Bullard, president of the Federal Reserve Bank of St. Louis, is not so sure.

Would we be better off if all speculative economic bubbles were eliminated?

James Bullard, president of the Federal Reserve Bank of St. Louis, is not so sure.

"Would you really want to go through the 1990s without the tech bubble?" Bullard wondered during a recent conference presentation in Philadelphia. Bullard was convinced that "a lot of good technology came out of it."

At the same time, he acknowledged that the bursting of the 1990s tech bubble and the 2000s housing bubble caused large-scale economic problems.

That recent history "may mean that monetary policy should put more weight on asset prices going forward," he said in the ever-cautious language of Federal Reserve officials.

Bullard did not mean that the Fed should keep a needle handy to start pricking bubbles, but rather that it has decided to study the issue carefully, investment manager David R. Kotok said.

That's a shift from the Alan Greenspan era. The former Fed chairman, who presided over two bubbles, believed that the only way to spot a bubble was by its bursting, economist Joel Naroff said. Current Fed Chairman Ben S. Bernanke has shown no more interest in pricking bubbles than his predecessor.

Underlying the Greenspan approach was the idea that markets are efficient, that prices are either where they should be or moving toward that point based on supply and demand. In that realm, demand falls when prices go up too much. But something else can happen in the world of finance and investment, involving stocks, bonds, and houses.

High and rising prices can actually stimulate demand, as seen in the frenzied tech-stock bubble and in the housing bubble, when house-flipping became a beloved hobby. What's more, asset prices also affect the real economy.

It's as if a thermometer could influence the temperature of the environment, to borrow an image from George Cooper's 2008 book, The Origin of Financial Crises. That makes it impossible to perceive the true temperature - or, by extension, the real condition of the economy.

Still, Cooper rejected as fallacious the argument that a central bank cannot identify bubbles. Doing so does not mean it needs to pin down correct house prices anymore than it needs to decide the correct price for a can of baked beans when it monitors consumer price inflation.

What the bank needs to do is determine a reasonable rate of price change, Cooper said.

After a century of inflation-adjusted home-price growth of 1 percent a year on average, the market took off in the late 1990s, climbing an average of 7 percent a year from 1997 to 2006, according to data from Yale University economist Robert Shiller. If a central bank can't spot that as a bubble, Cooper wrote, it might be better "to shut up shop altogether."

That won't happen, but the pressure is on to do something different after two tumultuous bursting bubbles in two decades.

This Economy: Starting Today

"This Economy," a weekly analysis by Harold Brubaker of financial issues that matter to the Philadelphia region. D2.