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America's top banker says we can't prevent economic bubbles, only contain the damage

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Fed chair Janet Yellen won't be shutting down the party

Italian Embassy / Flickr

There is a debate raging over whether or not the tech industry is entering another bubble. The massive valuations being earned by startups with little to no business model and the hordes of eager investors willing to back apps like Yo have led many to sound the alarm. There are signs that the credit market may be returning to its overheated ways, with subprime lending now higher than its 2008 peak. And the stock market is also roaring: in fact, the Dow Jones Industrial Average hit an all-time high of 17,000 today.

But in a speech yesterday, Janet Yellen, chair of the US Federal Reserve, said that she won't be raising interest rates anytime soon in an effort to put the brakes on the surging economy. In fact, Yellen questioned whether this tactic, long held to be the central banks' primary method for constraining an overeager market, actually worked at all."Monetary policy faces significant limitations as a tool to promote financial stability," Yellen told an audience at an event put on by the International Monetary Fund. "Its effects on financial vulnerabilities … are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment."

"Monetary policy faces significant limitations as a tool to promote financial stability."

Rather than try and contain the irrational exuberance that has led our economy on a boom and bust cycle over the last century, Yellen said the best approach was to ensure that whoever created these bubbles was healthy enough to clean up the mess when things went wrong. The Fed can do this by ensuring that banks hold more capital in reserve when buying stock on margin, for example, or by making sure they aren't over leveraged when creating exotic financial instruments like collateralized loan obligations.

There has been a lot of Monday-morning quarterbacking in the wake of the 2008 economic collapse, and the former chair of the Federal Reserve, Alan Greenspan, apologized for the lax approach to regulation, which he now concedes helped create the calamity. Many have argued that it was his unwillingness to raise interest rates that fueled the housing boom and set the stage for the collapse. Yellen, in essence, is arguing that interest rates alone are a poor tool for curbing bull markets, which are driven more by human nature than central bankers. Instead, she's looking to fix the other half of Greenspan's folly by ensuring that when things get out of hand, the people who cause the damage can afford to pay the bill.