Bubble spotters are mythical creatures, and the Fed can't pop them either

Prices for houses are generally back to where they were during the housing bubble that preceded the financial crisis a decade ago. What's worse, flipping is back.

That is the speculative practice of buying houses hoping to quickly sell for a gain. One report this spring said there hasn't been this much flipping since 2006 — more or less the frenzied peak of the last housing boom.

Neel Kashkari of the Minneapolis Federal Reserve seems oblivious to all this, at least according to critics knocking Kashkari's recent essay about asset bubbles and what the Fed ought to do about them. Kashkari's entirely sensible answer: not much.

And he made an even better point, that, even if the Fed did have something smart to do, it's highly unlikely anyone at the Fed managed to correctly spot an asset bubble forming in the first place.

The Fed's main policy committee — on which he sits this year — has entered a quiet period, so he couldn't discuss his views further. He wasn't trying to debate the housing market in his essay, just share a little insight about what the Fed can and can't do about problems that develop in the economy. Kashkari has his own unhappy experience looking for bubbles.

It was 2006, he wrote, when he worked for U.S. Treasury Secretary Henry Paulson. The secretary had observed that some sort of financial crisis seemed overdue, and he dispatched Kashkari and others to go look for a likely catalyst for trouble.

They came back with various blowup scenarios well worth following, but they never even considered the risk of a national housing price collapse and mortgage meltdown. How could they have missed it?

Part of the problem in trying to spot an asset bubble is that it's a curiously difficult thing to define. It is not just surging prices for assets.

There's more than one good explanation for why an asset bubble forms. By far the most fun to talk about is the irrational behavior of the people doing the buying. They keep at it just because prices seem to be going up and all their friends are buying and making a killing. Only then does buying a condo in Florida to flip actually start to sound like a really good idea.

A great analogy in the textbooks is of a herd of cattle out on the grasslands. Just a couple of the steers that start running will get a few more to take off running, too. Within seconds, enough could be on the move that it turns into a stampede.

The same herd mentality works on the downside, too, as greed gives way to fear and the herd stampedes off in the opposite direction. That is how bubbles burst. It's really only after the fact that it's obvious that's what just happened.

I was pointed toward economist and blogger John Cochrane of the Hoover Institution at Stanford University for a quick read on Kashkari's essay, and he came back with "Neel has this just about right."

Cochrane has written extensively about asset prices, and he suggested that Kashkari could have noted that if societies are prone to mass delusions and asset bubbles, why expect the people running the Fed to somehow stand apart from our society? They are not robots.

"If the Fed can [spot bubbles], so can every big hedge fund," he said, via an e-mail. "And then there won't be a bubble in the first place."

Kashkari's larger point is that the Fed doesn't have great options for what to do even if even if its staff saw an asset bubble developing. As a regulator, it can influence the banks it regulates. But as for its monetary policy tools, like raising short-term interest rates, that's a little like using a jackhammer to pop the balloons after a birthday party.

In his essay, Kashkari cited the price of crude oil, which not long ago was still at more than $100 per barrel. At that price, even sloppy operators in North Dakota were making money and a bona fide boom was in full swing. Was this an asset bubble? Would it have been shrewd for the Fed to start jacking up interest rates to prick the oil market bubble?

Well, it is not even clear that higher interest rates would have done much to oil prices. It is far more likely that there would have been a slowdown in housing construction and other important industries as rates inched up.

It's not the job of the Fed, or anybody else in government, to keep oil drillers, venture capitalists or hedge fund managers from investing foolishly. It is the Fed's job to promote financial stability, and Kashkari clearly worries a little more about the housing market. That is mostly because houses and apartment buildings are typically levered up with mortgage debt.

It was loan losses and threat of additional loan losses that caused the last financial crisis. Once the losses started hitting the books, a panic set in. The people who had lent the money to the banks and other financial institutions, like bank depositors, suddenly lost confidence.

Housing prices may have recovered since then but the abuses in the mortgage market, like the liars' loans of 2006, have not made a similar comeback. Another way to prevent the kind of thing that happened in 2007 and 2008, Kashkari mentions, is making sure the financial system is strong enough — and the individual banks capitalized well enough — for any blow to get absorbed.

As for the U.S. housing bubble alarmists of 2017, there's far more to proving a case of irrationally overvalued housing prices than pointing out that the Case-Shiller housing price index has climbed above 2006 levels.

And it appears Kashkari agrees.

"I appreciate [you] responding to my essay," he responded via Twitter to a blog arguing that spotting bubbles isn't difficult at all. "If so easy to spot bubbles, why tell us? Launch [hedge fund] and short 'em. Make trillions. No? Just talk then."

lee.schafer@startribune.com 612-673-4302