How Do You Deal With Bubbles?

Calculated Risk has a post this evening featuring Janet Yellen’s thoughts on asset price bubbles and the appropriate response to such phenomena. Her thrust seems to be that the Fed should be more attentive to the development of bubbles and act more quickly to control them.

Let me borrow from CR its excerpt of the speech.

[T]his evening I want to address another question that has been the subject of much debate for many years: Should central banks attempt to deflate asset price bubbles before they get big enough to cause big problems? Until recently, most central bankers would have said no. They would have argued that policy should focus solely on inflation, employment, and output goals—even in the midst of an apparent asset-price bubble. That was the view that prevailed during the tech stock bubble and I myself have supported this approach in the past. However, now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look.

Let me briefly review the arguments for and against policies aimed at counteracting bubbles. The conventional wisdom generally followed by the Fed and central banks in most inflation-targeting countries is that monetary policy should respond to an asset price only to the extent that it will affect the future path of output and inflation, which are the proper concerns of monetary policy. … policy would not respond to the stock market boom itself, but only to the consequences of the boom on the macroeconomy.

However, other observers argue that monetary authorities must consider responding directly to an asset price bubble when one is detected. This is because—as we are witnessing—bursting bubbles can seriously harm economic performance, and monetary policy is hard-pressed to respond effectively after the fact. …

What are the issues that separate the anti-bubble monetary policy activists from the skeptics? First, some of those who oppose such policy question whether bubbles even exist. …

Second, even if bubbles do occur, it’s an open question whether policymakers can identify them in time to act effectively. Bubbles are not easy to detect because estimates of the underlying fundamentals are imprecise. …

Now, even if we accept that we can identify bubbles as they happen, another question arises: Is the threat so serious that a monetary response is imperative? It would make sense for monetary policy makers to intervene only if the fallout were likely to be quite severe and difficult to deal with after the fact. …

Still, just like infections, some bursting asset price bubbles are more virulent than others. The current recession is a case in point. As house prices have plunged, the turmoil has been transmitted to the economy much more quickly and violently than interest rate policy has been able to offset.

You’ll recognize right away that the assets at risk in the tech stock bubble were equities, while the volatile assets in the current crisis involve debt instruments held widely by global financial institutions. It may be that credit booms, such as the one that spurred house price and bond price increases, hold more dangerous systemic risks than other asset bubbles. By their nature, credit booms are especially prone to generating powerful adverse feedback loops between financial markets and real economic activity. It follows then, that if all asset bubbles are not created equal, policymakers could decide to intervene only in those cases that seem especially dangerous.

That brings up a fourth point: even if a dangerous asset price bubble is detected and action to rein it in is warranted, conventional monetary policy may not be the best approach. It’s true that moderate increases in the policy interest rate might constrain the bubble and reduce the risk of severe macroeconomic dislocation. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, as Hyun Song Shin and his coauthors have noted in important work related to Minsky’s, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Nonetheless, these linkages remain controversial and bubbles may not be predictably susceptible to interest rate policy actions. And there’s a question of collateral damage. Even if higher interest rates take some air out of a bubble, such a strategy may have an unacceptably depressing effect on the economy as a whole. There is also the harm that can result from “type 2 errors,” when policymakers respond to asset price developments that, with the benefit of hindsight, turn out not to have been bubbles at all. For both of these reasons, central bankers may be better off avoiding monetary strategies and instead relying on more targeted and lower-cost alternative approaches to manage bubbles, such as financial regulatory and supervisory tools. I will turn to that topic in just a minute.

In summary, when it comes to using monetary policy to deflate asset bubbles, we must acknowledge the difficulty of identifying bubbles, and uncertainties in the relationship between monetary policy and financial stability. At the same time though, policymakers often must act on the basis of incomplete knowledge. What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences. This lends more weight to arguments in favor of attempting to mitigate bubbles, especially when a credit boom is the driving factor. I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles. However recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy. Clearly further research may help clarify these issues.

Another important tool for financial stability

Regardless of one’s views on using monetary policy to reduce bubbles, it seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face. Indeed, this was one of Minsky’s major prescriptions for mitigating financial instability. I am heartened that there is now widespread agreement among policymakers and in Congress on the need to overhaul our supervisory and regulatory system, and broad agreement on the basic elements of reform.
emphasis added

Ms. Yellen, as you can see, settles on regulatory and supervisory controls as a means of controlling bubbles. I find this both troubling and fanciful.

Troubling because it implies that the Fed or any other regulator possesses some sort of foresight not conferred on normal mortals. The differentiation between a bubble and legitimate economic growth will always be in the eye of the beholder. 

Fanciful because it assumes that a regulator operates in a vacuum. Politics and public opinion can not be managed out of the equation and so long as they are the final arbiters, bubbles are likely to grow and burst. Any regulator who attempts to control or deflate is certain to be reminded of those facts of life.

Bubbles come and go, they have as long as markets have existed. Some like the dot-com bust are huge, wipe out a lot of wealth but in the final analysis do little long-term damage. Why? Because they aren’t credit driven. Others, as we are finding out to our utter sorrow, do involve credit and they are terribly damaging.

The solution then is not so much to try and spot the bubble on the horizon but rather to control the amount of credit that can feed it. Regulations that control asset concentrations, shed light on sophisticated financial engineering products and limit the overall risk to an economy in the event of failure (smaller banks) might be a workable approach. 

Let’s not delude ourselves into believing that even when identified that a regulator will be able to control asset bubbles.


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