Rather than trying to manage bubbles, Bernanke's band of merry men should start by not inflating them in the first place.

There was a good piece in Harper's a while back about bubbles. The logic was tortured if you dug too deeply, but the overriding message was true: We've been creating new bubbles by managing the last one.

The "solution" to the Tech Bubble was to slash interest rates to record low levels. That, in turn, cut the price of monthly mortgage payments and sent housing prices on an upward spiral.

As house prices inflated, speculators and short-term investors moved in, and banks pushed the envelope of funding those speculators to make a quick buck. The advent of so-called NINJA mortgages - No Income, No Jobs, (No) Assets - marked the apex of this trend.

When home prices inevitably peaked, the banking system locked up, and the Fed's response was to flood the market with an unprecedented amount of money. The growth in money supply over the past few quarters has been near historical highs.

Not surprisingly, this growth has fueled into a boom in inflation-sensitive commodities. Now, investors are piling into that market as well.

The author of the Harper's piece thinks that high commodity prices will jump-start the next bubble ... in alternative energy technologies. That makes some sense, and it may already be happening.

I think Ben Bernanke's done a good job weathering some nasty developments in global financial markets. He deserves a lot of credit, for instance, for engineering the bailout of Bear Stearns by JPMorgan. But there are plenty of risks to all these interventions, as the recent and seemingly incessant string of booms and busts attests.

Really, if the Fed wants to start "managing" bubbles, they should go back and study that famous phrase from the Pogo comic strip:

We have met the enemy, and he is us.

There's an interesting piece in today's WSJ talking about the academization of Bernanke's bubbleology studies at the Fed.

A group of influential young academics is pushing the idea that the Fed should be much more interventionist around bubbles than it had been, for example under Alan Greenspan. The article in today's Wall Street Journal (subscription required) underscores the shifting black-magic nature of national economics. This fits in nicely with Matt's outline of the seemingly arbitrary shifts and adjustments to the CPI, in that you've got a handful of people using the national economy as a laboratory and making decisions that have huge impacts in people's daily lives.

It is absolutely worth a read. While I've got little faith in economists and academics and attempts to translate theory into reality, I guess on balance it's best that we've got our best minds engaged in trying to manage things a bit rather than open ourselves widely to wildly swinging economic cycles. This is all the more the case as the financial system, even as it becomes more hedged, ironically seems more open to large-scale, leveraged risk.

My personal sense is that with all of the interlocking derivative financial instruments out there, the economy is subject to huge risks that are sometimes hard to see ... the current mortgage crisis would be my Exhibit A. That sense coupled with the reality that oftentimes even smart, very big money can be duped on a large scale (hedge funds) or join the masses over the cliff of mean reversion as bubbles pop (tech, real estate, tulip bulbs, etc.) makes me, not so much nervous anymore, as resigned that we WILL go through large swings.

Indeed, if you spend all of your time thinking about all of the economic, political and financial risks in the world, you'll never get anything done. Best to just trust that the Princeton wizards have things in hand, and be ready when their best-laid plans fail to avert the latest disaster, as they have countless times through history. Happy investing!

You're not the only one skeptical about all of this, Matt. So apparently are bond traders dealing in Treasury Inflation-Protection Securities.

The break-even spread in 10-year TIPS widened after the most recent CPI data was released, notes John Jansen. An ex-official with the Federal Reserve Bank of New York and longtime bond trader, his daily blogs at the "Across the Curve" site are great reading. (I like to keep up with them through Seeking Alpha, as a matter of fact, which posts his latest and greatest comments).

Jansen noted that earlier in the year when financial markets seemed to be facing disaster (i.e., Bear Stearns going bankrupt), the spread between nominal bonds and TIPs traded on the wide end of this year's range around 257 basis points. As of yesterday, that was back to around 245 basis points.

That's notable, says Jansen, since the wider the spread gets, the greater the outperformance of TIPS relative to conventional nominal bonds.

A discussion with a portfolio manager indicated to him that "many participants think that there was an overly aggressive seasonal factor applied this month (in the CPI data) which depressed the inflation rate."

Jansen added that many traders and portfolio managers seem to be waiting "for the next round of data, which they believe will manifest inflation in a more virulent form."

My theory is that they read Matt's blog and instantly pulled back ... what was the exact timing of your post?

In any case, I'm off to Long Beach, Calif., in the morning to take in the big conference put on each year by the National Association of Personal Financial Advisors.

I hope to run into Rob Arnott, Norman Boone and Eugene Fama, among others at the event (which started Wednesday and runs through Friday). They'll be making presentations and we'll be reporting back to our faithful at IndexUniverse about what should be a very interesting series of workshops and roundtable discussions on investing.

Stay tuned ...

The issues around investing in both Europe and the United States are daunting, but it's worse in Europe.

Matt - I want to talk some more about Europe per your request, because comparing and contrasting the issues that Europe and the U.S. face is a great way to get some perspective on the situation in different countries around the world. To my mind, the biggest issue in developed nations around the world is that not enough sensible policy-making is being put into place to help ensure the maximum economic benefit for retirees and our societies.

To answer your question specifically, the most important problem in Europe is the lack of open competition. If you think distribution channels for investment products are closed and commission-driven in the U.S., try out Europe! In a system largely driven by banks that have lived a very comfortable, padded existence, there are few in the industry who are interested in changing the status quo and going directly to investors or (what a concept) in advocating fee-based advisors who actually have the interests of their clients in mind.

As you know, I've talked about this often (thanks for your feedback on my latest 401(k) post to those who emailed me). The issues in Europe highlight the problems in the U.S. And frankly, I do see a number of paths we could go down to improve the system, but I'm very disappointed with the amount of thought and vision that has been focused on these issues by those of us in the financial services business who are in the best position to effect policy change that could bring sweeping benefits to our economies and our societies.

In fact, when I brought up the subject of the demise of defined benefit and defined contribution plans on the (very lively) panel I sat on in London, there was an almost virulent response from a couple of the panelists and some attendees. Clearly, there is some great bitterness toward the "mother state" of the U.K. in particular, which was to some degree dismantled during the Thatcher years. The reaction from a German participant on the panel, Karl Olbert, was that companies should not have risks put on them that have nothing to do with their business.

My overriding point is that I'd like to take the ideology OUT of it and look at things as pragmatically as possible. What has been the effect of us making a wholesale shift of retirement risk from companies and countries in the form of DB plans to DC plans? Despite how poor some of the pension investing has been, I've still got to believe that by and large, the answer is "worse investment decisions and lower returns."

And for the people in the bottom quarter? half? Forget it - it's sort of sink...or sink, on the ever-diminishing Social Security benefits that Matt refers to. We need to address these issues, and we need to address them now.

There is plenty of money to be made by all, but we don't need to operate on the inefficient robber-baron model that is the 401(k) - a veritable boon for the financial services industry, but of dubious relative value to investors who are pouring the bulk of their assets into some of the worst financial products available. Still, with the proposition of the 401(k) being scrapped seeming slim, at least we should mandate some decent offerings, sensible plan defaults and greater responsibility of plan sponsors to actually act in the interest of the participants (eliminating conflicts of interest that manifest themselves as company kickbacks) and greater responsibility to educate participants.

And in terms of the broader issue, shouldn't we be doing something to help optimize the returns of the large government benefit schemes to help optimize the payout that today's workers are putting into the Social Security system, whether this takes the form of sensibly defaulted private subplans or (better in my eyes) broad, diversified investments by the larger pool of assets? I recognize that there are very difficult issues here around risk and conflict, but the simple fact of the matter is that we should be more efficient as a society with how we manage the pools of assets that are increasingly necessary for longer times for more investors with fewer young workers supporting them.

The demographic trends in Europe AND the U.S. are disturbing, and indicate not only a much lower ratio of contributing workers to retirees, but also potential lower returns caused by the necessary drawdown in investments as baby boomers enter retirement.

These are serious issues. And while I'll be socking away retirement funds that will make sure I don't starve, I do feel that it's incumbent on those of us who are actually focused on the sophisticated risk-controlled investing strategy to put more effort into thinking about these big-picture issues.

Why is Europe lagging on the retail front, Jim? Is it just the advisory model?

Or is there a lack of education and/or products? Is the culture of indexing just less developed there?

Give us more from London...

Regarding the CPI, yes, I did a big write-up on it in the January 2005 issue of the Journal of Indexes. My article was called "CPI Two-Step," and it's one of the better pieces I've done. You can find it here.

The thing about the CPI is that it's easy to brush off the inconsistencies. The government uses a higher weight for cigarettes than prescription drugs. Ha Ha.

But the CPI is hugely important. In fact, it's the single most important index in America.

The government uses the CPI to make cost-of-living adjustments to Social Security, military pensions, federal pensions, food stamps, school lunches, tax brackets, TIP payouts and more. The difference of 0.5% one way or the other is measured in the billions of dollars.

Take healthcare. Healthcare represents 6% of the CPI, yet makes up 16% of our GDP. Riddle me that. And according to the National Coalition on Health Care, healthcare costs jumped 6.9% in 2007—more than twice the official rate of inflation. If you tripled the weight of healthcare in the CPI, bringing it even with reality, that alone would have a major impact on the final CPI.

Look at it another way: I'm 31 years old. Assuming it still exists, I'll get my first Social Security payment in 37 years. Let's suppose that the CPI runs 3% per year until then, but it understates "real" inflation by 1% a year. Whammo-presto, my check is worth 29% less in today's dollars. If the CPI understates inflation by 2%, my check loses 50% of its value.

I better increase my contribution to the 401(k) plan...