Next on Obama's to-do list: A bubble-free economy

WASHINGTON (Reuters) - President Barack Obama thinks the last two U.S. economic expansions were bubble-driven and wants to make sure the next one isn't.

It is a noble ambition but one that raises long-debated questions about what causes asset price bubbles, how to accurately spot them as they are inflating, and whether they ought to be popped before they burst.

Obama is hoping the regulatory overhaul he proposed this week will help prevent dangerous build-ups in risky investments such as the mortgage-backed securities that touched off the current recession.

But his choice for chief risk watchdog is the Federal Reserve, an agency with a controversial history of ignoring bubbles until they pop -- with catastrophic consequences.

While Obama has not taken a clear public position on whether the central bank ought to intervene when bubbles are building, his top economic adviser, Lawrence Summers, said the president was no fan of the current approach.

"The president does not accept the judgment that it is best to let market forces rip and then when there's an accident clean up after it," Summers told a small group of reporters shortly after Obama announced his reform plan on Wednesday.

He said Obama thought the dot-com euphoria of the late 1990s and the more recent credit boom meant the last two economic cycles were built on unsustainable bubbles, and the next expansion must rest on a stronger foundation.

"That would be a utopian economic dream," Senator Richard Shelby, the top-ranking Republican on the Senate Banking Committee, said on Reuters television on Thursday.

In Obama's view, regulation is the key. The hope is that tightening rules on how much banks can borrow and re-lend and how much capital they must hold to backstop those loans will curb the excesses.

The knock on clamping down on credit is that it slows the economy. Obama may be betting that after two painful busts in the span of less than a decade, Americans are willing to accept slower growth if it means getting off the roller-coaster.

Bubbles are popular -- before they burst. They bring low unemployment, high consumer confidence and enormous amounts of wealth. The satirical newspaper The Onion wrote a story last year headlined, "Recession Plagued Nation Demands a New Bubble to Invest In." Jokes aside, the feel-good factor does help explain why policymakers often fail to stop bubbles early on.

UTOPIAN DREAM

There is no denying the economic pain inflicted by the tech crash of 2000 and the more recent housing bust. Unemployment is at its highest level in 26 years and will probably keep climbing well into 2010.

But there is little consensus on what causes bubbles and why the U.S. economy is so prone to them, which makes it difficult to determine the best way to prevent them.

In the current episode, some blame the Fed for keeping interest rates too low for too long in the early part of this decade, which heated up the housing market.

Former Fed Chairman Alan Greenspan and his successor, Ben Bernanke, have dismissed that argument. They point out that mortgage rates remained low even after the Fed began hiking its benchmark interest rate, and the housing boom was not confined to the United States. Spain and Britain were among the countries that also saw a huge run-up in house prices.

Under Greenspan and Bernanke, the Fed's position has been that the central bank should not use monetary policy to pop bubbles because it is hard to determine in real time whether one is forming. Indeed, Greenspan and others saw the early phase of the dot-com bubble as a productivity boom brought on by the widespread use of computers.

Raising interest rates can trigger a recession, so the Fed is understandably cautious about using such a blunt instrument to prick a bubble -- particularly when it is unsure about whether one even exists.

But attitudes toward that may be shifting. Janet Yellen, president of the Federal Reserve Bank of San Francisco, said the Fed probably should consider stepping in to stop the most dangerous bubbles -- those powered by credit booms.

"It is now patently obvious that not dealing with some bubbles can have grave consequences," she said in a speech earlier this month.

"I would not advocate making it a regular practice to lean against asset bubbles. But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor."

Putting the Fed in charge of big-picture risk regulation may actually help solve the Fed's bubble dilemma.

Fed officials say privately that giving the central bank regulatory authority over large financial firms would allow them to stop unusual concentrations of risk without having to make the judgment call about whether a bubble was building.

Anil Kashyap, an economics professor at the University of Chicago's Booth School of Business, said that may be the best approach. He said the Fed's 2007 estimates that the housing bust would cause only minimal bank losses shows that officials misunderstood the role of leverage in this crisis.

"I think the Fed would say that they missed this and now accept that monitoring this is critical going forward," he said. "So regardless of whether one backtracks on spotting bubbles, I think they will want to watch leverage cycles much more closely."