Dudley calls for regulation to combat bubbles

William Dudley, president of the Federal Reserve Bank of New York, said on Wednesday that central banks need to put an emphasis on regulation, and not interest rates, to manage asset price bubbles.

His comments to the Economic Club of New York, a non-partisan forum, came just a few hours after Alan Greenspan, former Federal Reserve chair, told an inquiry panel that he had misjudged the severity and timing of the bursting of the real estate bubble.

Mr Dudley, also a former chief US economist at Goldman Sachs, said that monetary policy does not target the root causes of bubbles, such as the one in real estate that precipitated the financial crisis, and using it to lower asset prices could cause more harm than good.

Monetary policy is less effective than regulation, he said, ”because it is too broad” and can be too costly ”in terms of lost output and employment.” Raising rates can also strain budget deficits.

”It’s clear to me that the fiscal path that the US is on today is not sustainable over the long term,” he said.

Market structures that limit short selling, complex financial innovations, compensation policies that reward unwise behaviour and a bias toward optimism help drive prices to a level unrelated to the fundamental value of the underlying asset.

In the current crisis, poorly understood innovations such as collateralised debt obligations and subprime lending practices left markets unable to correctly price assets.

”The structured finance models appeared to be sound because losses on the underlying subprime mortgage loans were low,” he said.

He recommended regulation and supervisory actions to limit loan to value ratios, limit leverage, and raise taxes on housing transactions, among others reforms. He also said increasing the ability of investors to short assets ”’might be helpful.”

”Several Asian and European countries have used such tools to limit speculative real estate activity, apparently with some success,” he said.

”[My] view is that we need to be a little bit more proactive in this respect.”

Canada’s ”tougher regime,” Mr Dudley also said, explains why the Canadian financial system was ”less affected by the global financial crisis than the United States.”

He and other members of the Fed are closely monitoring global regulatory reform.

”We’re spending a lot of time in Basel these days,” he said.