Kohn: Research needed on combating bubbles

Federal Reserve policymakers should deepen their understanding about how to combat speculative bubbles to reduce the chances of another financial crisis, the central bank's outgoing vice chairman said Wednesday.

Donald Kohn said the worst crisis to hit the country since the 1930s points to the need for more research on how higher interest rates can be used to limit financial speculation. Kohn suggested that, and other "homework assignments," in remarks prepared for a lecture at Davidson College in North Carolina.

Given the limited research, Kohn said he favors using regulation to prevent new speculative bubbles from developing that could burst and plunge the economy into a recession. Higher rates could be used if stronger regulations don't work, he added.

Kohn acknowledged that the recent crisis tested the Fed's understanding of the economy and its tools to turn the situation around.

"Many central bankers and economists, myself included, were a little complacent coming into the crisis," Kohn said. "We thought we knew enough about the basic structure of the markets and the economy to achieve economic and price stability with relatively minor perturbations. ... The reality is that we didn't understand the economy as well as we thought we did," he said.

A 40-year veteran of the Federal Reserve system, Kohn plans to step down at the end of June.

Kohn helped devise the Fed's strategy to fight the recession and the financial crisis. The Fed slashed interest rates to a record low near zero and rolled out a series of unprecedented programs aimed at getting credit flowing more freely again. Many credit the Fed's actions with preventing the Great Recession from turning into the second Great Depression.

A housing boom that went bust thrust the country into economic and financial chaos. That's why it is important for policymakers to sharpen their knowledge about how to better combat speculative excesses, Kohn said.

Another "homework assignment" suggested by Kohn involves research on helping the Fed better understand various effects of programs for buying mortgage securities and government debt.