However, as has been the case in previous instances of rapid financial innovations, adequate mechanisms to control excessive risk-taking may not have been in place during the subprime market’s greatest growth.  One innovation, further development of securitized products, gave mortgage lenders greater access to the capital markets and spread risks more broadly.  However, securitization also widened the separation of the originators from the ultimate holders of the loans--that is, those who bought securities backed by loans.  In this setup, a classic principal-agent problem can arise if originators (the agents) do not have a sufficient incentive to shield the owners of the securities (the principals) from suffering higher-than-expected losses. 

As you know, I'm a new central banker and policymaker. But I bring to this new role experience in the financial sector touching on a wide range of business lines, asset classes, and types of institutions. I know during a feast there is a strong incentive for market participants to meet the competition and seek competitive advantage by pushing the risk-reward envelope.

Some of this pushing of limits amounts to sustainable innovation. Many of these innovations served desirable ends and allocated greater risk to those investors who had an appetite for it. The subprime mortgage market has brought the American dream of home ownership to many people who previously could not qualify for mortgage loans. These developments, on balance, have been a good thing. But some pushing of limits, in my view, will prove to have been imprudent excess.

Large run-ups in asset prices present serious challenges to central bankers. The analysis of the role of housing in the monetary transmission mechanism argues against a special role for house prices in the conduct of monetary policy and in favor of a policy response to them only to the extent that they have foreseeable effects on inflation and employment. Nevertheless, central banks can take measures to prepare for possible sharp reversals in the prices of homes or other assets to ensure that they will not do serious harm to the economy.   

Although this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans. In part, these wider losses likely reflect concerns that weakness in U.S. housing will restrain overall economic growth. But other factors are also at work. Investor uncertainty has increased significantly, as the difficulty of evaluating the risks of structured products that can be opaque or have complex payoffs has become more evident. Also, as in many episodes of financial stress, uncertainty about possible forced sales by leveraged participants and a higher cost of risk capital seem to have made investors hesitant to take advantage of possible buying opportunities. More generally, investors may have become less willing to assume risk. Some increase in the premiums that investors require to take risk is probably a healthy development on the whole, as these premiums have been exceptionally low for some time. However, in this episode, the shift in risk attitudes has interacted with heightened concerns about credit risks and uncertainty about how to evaluate those risks to create significant market stress.

Monetary policy, or the short-term interest rate, is not a good tool for leaning against or trying to pop asset price bubbles for a variety of reasons, including the fact that it is very difficult for us to know when an asset price is in a bubble; it’s very hard to know how the asset price would react to increases in interest rates; it’s hard to know what to do when some asset prices might be in bubbles and others not; it’s a concern what would happen to the real economy if you raise interest rates a lot to pop a bubble and the higher interest rates have adverse effects on the real economy. So there a lot of unknowns and uncertainties that make me very cautious and conservative about thinking about using monetary policy to address asset prices.

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

     "At the present time, stock market valuation doesn't seem to be elevated, certainly not as it was at the end of 2000. And the latest information on manufacturing, the ISM report, was apparently quite strong.''

     ``We don't see the accumulating evidence that would justify ongoing market declines. Should that happen -- I'm not trying to predict that the stock market will go one way or another because I know that's a very dangerous thing to do -- should the market decline without any underlying supporting evidence to justify the declines, then I would say my own view would certainly be that it's a fluctuation in the market of the type that occur that are very difficult to understand or explain.''

     In ``the absence of other information there would be no particular reason for the FOMC to respond to the stock market itself.''

In comments to reporters after his speech, as reported by Bloomberg News

If we can identify bubbles quickly and accurately, are reasonably confident that tighter policy would materially check their expansion, and believe that severe market corrections have significant non-linear adverse effects on the economy, then extra action may well be merited. But if even one of these tough conditions is not met, then extra action would be more likely to lead to worse macroeconomic performance over time than that achievable with conventional policies that deal expeditiously with the effects of the unwinding of the bubbles when they occur. For my part, I am dubious that any central banker knows enough about the economy to overcome these hurdles. However, I would not want to rule out the possibility that in some circumstances, or perhaps at some point in the future when our understanding of asset markets and the economy has increased, such a course of action would be appropriate.

Monetary policy does not today and is unlikely in the future to offer us an effective tool for directly reducing the incidence of large or sustained deviations of asset values from what might turn out to be their fundamental values, what some call bubbles.

Relying on policymakers to perceive when speculative asset bubbles have developed and then to implement timely policies to address successfully these misalignments in asset prices is simply not realistic.

The FOMC knew [in the 1990s] that tools were available to choke off the stock market boom, but those tools would only have been effective if they undermined market participants' confidence in future stability. Market participants, however, read the resilience of the economy and stock prices in the face of monetary tightening as an indication of undiscounted market strength.

CNBC INTERVIEWER: Tell me, what is the worst-case scenario? We have so many economists coming on our air saying ‘Oh, this is a bubble, and it’s going to burst, and this is going to be a real issue for the economy.’ Some say it could even cause a recession at some point. What is the worst-case scenario if in fact we were to see prices come down substantially across the country?

BERNANKE: Well, I guess I don’t buy your premise. It’s a pretty unlikely possibility. We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.

Not all situations in which asset prices are rising rapidly under seemingly easy monetary conditions are worrisome. Some are quite benign and even signal a healthy economy.

To the extent that current spending behavior is built on realistic expectations--in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation--the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth. Eventually, reality always asserts itself over wishful thinking, and such realignments are sometimes abrupt, as illustrated by the collapse of the high-tech bubble a few years ago. In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track.

Perhaps the greatest irony of the past decade is that the gradually unfolding success against inflation may well have contributed to the stock price bubble of the latter part of the 1990s.  Looking back on those years, it is evident that technology-driven increases in productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to stock prices.  At the same time, an environment of increasing macroeconomic stability reduced perceptions of risk. In any event, Fed policymakers were confronted with forces that none of us had previously encountered. Aside from the then-recent experience of Japan, only remote historical episodes gave us clues to the appropriate stance for policy under such conditions. The sharp rise in stock prices and their subsequent fall were, thus, an especial challenge to the Federal Reserve.

It is far from obvious that bubbles, even if identified early, can be preempted at lower cost than a substantial economic contraction and possible financial destabilization--the very outcomes we would be seeking to avoid.

In fact, our experience over the past two decades suggests that a moderate monetary tightening that deflates stock prices without substantial effect on economic activity has often been associated with subsequent increases in the level of stock prices.6 Arguably, markets that pass that type of stress test are presumed particularly resilient. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.