Ben Bernanke's bubble trouble

Ben Bernanke, the Federal Reserve chairman, has a little problem.

He missed one of the biggest housing bubbles in history as it swelled right under his nose.

Now, as he goes through the process that will probably see him re-appointed to a second term, he’s enduring a beating from U.S. Senators who want him to promise to do better.

The results of Bernanke’s confirmation hearings will have a lot say about the future role of the Fed chairman. It may also determine how other central bankers around the world conduct themselves in the years ahead.

The big question is whether the Fed will now act preemptively to diagnose bubbles as they happen and pop those bubbles before they get too big. Central banks have long fought against this role because it requires them to be smarter than the market.

The standard view, held by people such as Alan Greenspan, has been that the market knows best and that no central banker should try to outguess it. After all, who has more incentive than private investors to determine if surging stock prices or home prices reflect reality? Sure, bubbles may sometimes happen, but mainstream economists have long argued that the right way to deal with them is for the central bank to clean up the mess after the bubbles pop, but not before.

The dotcom bubble and the housing bubble have shown up the flaws in that approach.

Now Bernanke is trying to have it both ways.

He told senators at his confirmation hearings on Thursday that “it’s very difficult to know if asset prices are appropriate or correctly valued.”

(In other words, the standard Greenspan-era shrug.)

On the other hand, he also told the Senate that the Fed has been looking at valuation models: “We do not see at this point any extreme valuation of assets in the United States.”

(That sounds as if the Fed is trying to diagnose bubbles as they happen.)

At the very least this leaves Bernanke in an uncomfortable corner.

Now that he’s gone on record once as saying there are no bubbles in the United States, how can he ever stop issuing updates on the situation?

To refuse to answer the question would be tantamount to saying that, yes, there are bubbles. Like it or not, Ben Bernanke has just become a bubble-ologist.