Tuesday, July 7, 2009

Preventing Bubbles

Baseline Scenario touches on the Fed's newfound desire to manage asset bubbles here.

I'm a little bit skeptical of the Fed's ability to do this. They didn't seem to learn much from the dotcom and real estate bubbles.

There will always be bubbles, in the sense that, in the universe of capital allocation, there will always be some segment that is less efficient.

In other words, there will either be perfect equilibrium, or a bubble(s). So the idea that we can eliminate or prevent all bubbles is illusory.

Given that, the question before us should be how to minimize bubbles, and how to isolate their impact.

As always, I think we need to start with reducing leverage and complexity. Complexity feeds bubbles by obscuring their existence through a reduction in market information. Leverage is the mechanism by which they metastasize.

Focussing on these two problems would be a good place to start.

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