Harris: Get to Know Bernanke's Fed

This column was written by Ethan Harris, co-chief U.S. economist for Barclays Capital (BCS Quote) and author of the new book Ben Bernanke's Fed: The Federal Reserve After Greenspan.

It is often said that the Fed chairmanship is the second most important job in America. And yet, while there are many books about Alan Greenspan, there have been no books written about Ben Bernanke -- until now.

Contrary to popular belief, Bernanke is not Greenspan with a beard. Indeed one of the big mistakes investors have made in the last two years is to view Bernanke through Greenspan glasses. Bernanke's policies are shaped by a very different background than his more famous predecessor.

Consider the most important questions of the day: How should the Fed behave if it suspects an asset bubble, and what should it do if that bubble bursts? While there is intense soul-searching going on, the consensus at the Fed is that central banks should take an "asymmetric risk management approach" to suspected bubbles. That is, it should not react to bubbles as they develop, but should react strongly when they pop to avoid serious collateral damage to the economy.

Why not react to a suspected bubble? Bernanke and others see three problems with preemptive strikes against asset bubbles. First, bubbles are hard to identify in real time. Specifically it requires that the Fed believe it can outguess the collective wisdom of the market. Second, even if a bubble is identified, policy lags make it hard to counter. By the time Fed policy kicks in, the bubble may be deflating of its own accord. Third, monetary policy is the wrong tool for popping a bubble. Aggressive actions may be required, causing serious damage to the economy. Bernanke likens it to doing "brain surgery with a sledgehammer."

I would add a fourth reason for stepping aside in the face of a potential bubble: Attempting to stop a bubble could expose the Fed to severe political criticism. The Fed does not want blood on its hands when the markets retrench; it would rather the markets suffer self-inflicted wounds.

Frankly, I've never found the Fed's arguments convincing. There is no question that asset bubbles pose a difficult challenge to central banks. However, all of the problems the Fed faces in countering asset bubbles also apply when the Fed is countering an overheating economy.

In both cases the Fed must grapple with imprecise models, policy lags and political risks if mistakes are made. If the Fed can take away the punch bowl when inflation threatens, surely they can water down the punch bowl when asset market parties get out of hand. Leaning against bubbles should be part of the Fed's risk management strategy. When Greenspan started to suspect "froth" in the housing and credit markets he should have abandoned the super-slow 25 basis point rate hikes and tightened monetary and regulatory policy.

So much for the inflation phase of the bubble. What about when the bubble pops?