Does the Federal Reserve cause asset bubbles?

         After crashes in the economy - most notably the housing crash - one wonders what causes severe crashes that seem to come on suddenly and violently.  The question arises, "Can the Federal Reserve (FED) cause bubbles in the economy?" like the housing bubble that popped in 2006 or 2007 depending upon your location. 

         Unfortunately, the Federal Reserve does have the tools to create and/or exacerbate existing bubbles.  For those not familiar with economics this would be the power to buy and sell treasury securities (Bills, Notes, Bonds) on the secondary market.  They purchase the securities with an unlimited checking account.  They create money out of thin air and buy the treasury securities.

         There are two things that happen as the result of this: the FED, more specifically, the FOMC - the Federal Open Market Committee - injects indirectly more money into the economy and (2) they lower the rate of interest to which banks lend to each other called the Federal Funds Rate (FFR).  Now, they do not lower the rate directly; however, it is irrelevant because the FFR always lowers in accordance to what the FED wishes it to become or falls within their accepted expectations called the Federal Funds Target Rate. 

         It is of little importance to go into the draconian details herein about how the above happens.  What is important is that everyone understands the consequences of the above.  The FED lowers the rate of interest, indirectly, on the FFR to get banks to lower the interest rate they charge on their loans.  However, it is also of great importance to understand that not only is the interest rate lower now, but because of our fractional reserve banking system, the newly purchased securities' money will be deposited into the banking system and then lent out by banks.  This results in the expansion of the money supply and therefore, inflation.  So, banks have more money to lend and lend money out at cheaper rates of interest.

          This sounds good to business owners who have been waiting to start projects but believed them to be unprofitable because of the rate of interest in terms of borrowing was too high making it unfeasible.  Now, however, with the new rate of interest being drastically lower, the project now appears to be profitable.  This results in business owners taking on projects that are usually capital intensive and time consuming.  Business owners invest in capital goods like housing construction, heavy equipment etc.  Consumption - which is the opposite of savings - ramps up high as investment takes place and unemployment goes down.  Wages rise with the growing shortage of laborers and prices on consumption goods rise accordingly. 

            As inflation shows up in prices as analyzed by the FED, they take action by doing the only thing they know how which is to raise the rate of interest.  They do this by selling their previously purchased securities.  So what they end up doing is take money out of the economy now instead of inject it.  As the costs of production rise and savings - the opposite of consumption - being depleted by the previous consumption the booming economy turns into a bust.  There are not enough savings to purchase all the goods and services that were produced during the booming period that are now finished.  Workers get laid off and production, investment and consumption fall.  People start to save as the liquidation begins of all the goods and services in question.  As workers get laid off and the labor market rises the wages fall.  The FED causes a "boom and bust" cycle.

          This is essential if one is to understand how the FED can influence and/or cause bubbles in the economy.  When the FED buys securities it can influence people into the stock market and it does.  This lowering the rate of interest means lower interest rates the banks are willing to pay savers.  That is to say that people are discouraged from saving and encouraged to jump into the risky and volatile stock and/or bond market to further improve their financial status or at least try to outpace inflation.  This increases speculation and trading in the stock market leading to stock price fluctuations that are above the natural price to the extent that when the market realizes the extent of the speculation and real valuation becomes apparent, the speculative price will crash to about the natural price - the real or actual pricing mechanism based on purely facts and figures about the company's financial position - (possibly lower) as a natural corrective measure.  The real problem is that these "corrections" are usually sudden and violent.  Violent meaning that multiple stocks and/or groups doing this at once can trigger excessive panic and further perhaps even unnecessary changes in prices of stocks through fear and uncertainty. 

         The other bubble that this might create or at the very least will exacerbate is a housing bubble.  The FED did exacerbate and to some extent, help facilitate the start of the housing bubble by setting rates low (Greenspan about 1%) in 2001 which started the housing boom.  This was further agitated by exotic loans that were made to people who should not receive them.  This is not narrowed to "sub-prime" loans but exotic loans meaning little to no down-payment, sometimes even financing 107% of the home's value in a purchase!  The exotic and sub-prime loans were probably the biggest culprit in the housing debacle.  However, these exotic and risky loans were the actual results of failed governmental policies and government intervention in the economy. 

           Fannie Mae, Freddie Mac, and FHA - all Government Sponsored Enterprises - are realistically, at the root of the crisis as well as other governmental agencies that promoted "affordable housing" and the like.  We, meaning the United States, have a socialized housing sector.  Close to 99% of all home loans are subsidized by the Government Sponsored Enterprises (GSE) listed above.  The FED has already bailed out Fannie and Freddie; yet, with hundreds of billions of dollars provided in liquidity, Fannie and Freddie couldn't hold their stock price of the one dollar minimum price requirement set by the New York Stock Exchange and were kicked out.  We have a socialized housing sector, and wouldn't you know it, it's not working.  

       So, does the FED create bubbles?  You bet it does, unintentionally or not is not the question.  Other great economists, like Milton Friedman, criticized the FED for a long periods of time before finally coming to the conclusion that the FED should just be abolished as well as all other central banks.  The question then becomes what currency to use after the FED is finally gone?