SINCE early 1998 The Economist has repeatedly argued that the Federal Reserve should have tightened policy sooner to let some air out of America's economic and financial bubble. This view won us few friends in America; most commentators even denied that it was a bubble. Yet most now agree that it was perhaps the biggest financial bubble in American history. It has also been the biggest bust, with almost $7 trillion knocked off share values since early 2000—more, as a share of GDP, than after the 1929 crash. As the imbalances created by this bubble continue to hold back America's economy, more people are starting to point the finger of blame at the Fed.
Such criticism last week provoked Alan Greenspan, the Fed's chairman, to defend his record (see article). Mr Greenspan argued that central banks cannot use interest rates to prick bubbles in their early stages because they can never be sure if there is a bubble or not. Moreover, he said, interest rates are a crude weapon. A rise in rates sufficient to prick a bubble could push the economy into recession.
Dealing with bubbles is devilishly difficult, but Mr Greenspan overstates his case. Uncertainty should not mean inaction: central banks do not shy from stamping out inflation just because they are unsure about the size of the output gap. And if by pricking a bubble a central bank causes a recession, that may still be better than the alternative of letting financial imbalances worsen, raising the spectre of a much deeper recession when the bubble eventually does burst. The longer the party continues, in short, the worse the eventual hangover.
The job of a central bank is not just to prevent inflation, but also to ward off threats to economic and financial stability. Central banks should not set targets for asset prices. But a sharp rise in share prices accompanied by a big increase in borrowing should set alarm bells ringing. Heavy borrowing leaves firms and individuals dangerously exposed: when asset prices collapse, the nominal value of their debts remains fixed, creating severe balance-sheet problems for households and firms—as Japan has painfully discovered since 1990.
It would have been better if the Fed had raised interest rates earlier in the late 1990s to head off America's stockmarket boom. Yet its mistake was understandable, because central banks do not have a mandate to prick asset-price bubbles. The awkward truth is that bubbles are popular. The public regards high inflation in the prices of goods and services as a bad thing, but rising property and share prices as good things. Central banks' independence goes only so far. If the Fed had raised interest rates when inflation was low and succeeded in pushing down the stockmarket, thereby trimming the wealth of the 50% of Americans who own shares, Congress might have been tempted to curb the Fed's power. No wonder central bankers prefer to let bubbles pop in their own good time. But if, as a result of its bubble bursting, America now suffers several years of sluggish growth, or worse, they may think again.
A less forgivable mistake was that Mr Greenspan acted as something of a cheerleader for the “new economy”. Even if some of the increase in productivity growth was real, his enthusiasm contributed to investors' euphoria. They seized on all of his comments to justify their bullishness about future profits. Ironically, Mr Greenspan was among the first to give warning of a bubble in 1996, drawing attention to the market's “irrational exuberance”. What a pity he failed to put America's monetary policy where his mouth (briefly) was.