How to Blow Market Bubbles

Simon Johnson, former Chief Economist at the IMF, and MIT Sloan School professor provides a well thought out explanation of how market bubbles form in "How to Blow A Bubble." Earlier this year in May, Johnson penned the Atlantic magazine article - "The Quiet Coup: How Wall Street Captured Government."

First he gives credence to Rolling Stone columnist Matt Taibbi, author of the now famous expose on Goldman Sachs, for shedding light on "market microstructutures"

"- not the technological variety usually studied in mainstream finance, but more the politics of how you construct a multi-billion dollar opportunity so that you can get in, pull others after you, and then get out before it all collapses.  (This is also, by the way, how things work in Pakistan.)"

Johnson then provides his own view of Goldman Sachs has provided monetary policymakers with the ammunition and the will to make decisions that are ultimately responsible for the formation of bubbles:

Now it seems the ideological initiative may be shifting towards Goldman Sachs.

As Bloomberg reported on August 5th, “Goldman economists, led by Jan Hatzius in New York, now see a 3 percent increase in gross domestic product at an annual rate in the last six months of this year, versus a previous estimate of 1 percent. The new projections were included in a research note e-mailed to clients.”

Goldman’s public thinking, of course, has been that we face such slow growth that interest rates should be kept low indefinitely.  There is, in their view, no risk of inflation – and no such thing as potentially new bubbles (e.g., in emerging markets). The adjustment process will go well, as long as monetary policy stays very loose – it’s back to Bernanke’s 2003 line of thinking.

This line of reasoning has been very influential – reinforcing Bernanke’s commitment not to tighten monetary policy in the foreseeable future and fitting in very much with the Summers model of crisis recovery.  Just a couple of weeks ago, in his July 14 report, Jan Hatzius argued, “further stimulus remains appropriate” and “the appropriate debate is not whether fiscal and monetary expansion is appropriate in principle but whether it has been sufficiently aggressive.”  I don’t know if he has revised this line in the light of the big upward revision in his growth forecast or whether he is still saying, “Ultimately, we do expect further stimulus, but it may take significant disappointments in the economic data and the financial markets before policymakers move further in this direction.”

Much faster growth than expected is, of course, in today’s context a good thing.  But it also brings complications.  If you keep monetary policy this loose for much longer, you will feed bubbles.  And if you encourage even looser monetary and fiscal policy, there will be a costly reckoning not too far down the road.


...Next time, our big banks will take another massive hit – quite possibly bigger than what we saw in 2008. 

Goldman and its insiders are ready for this.  Are you?

Read the whole article and others by Simon Johnson at Baseline Scenario.

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