Central Bank Response to Asset Price Bubbles
Recent research in the area of macroeconomics has been focused on trying to identify the causes of the 2007 – 2008 global financial crisis and determining best central bank monetary policies to prevent future crises. A debate that has for the last few decades been settled is now being revived; “lean” versus “clean” handling of asset Price bubbles.
The prevailing consensus of central bank monetary policy has followed the “Greenspan Doctrine” established in the 1970’s for dealing with asset price bubbles. Alan Greenspan, who was the chairman of the U.S. Federal Reserve from 1987 to 2006, believed that cleaning up after an asset bubble burst was less costly and damaging to the economy than allowing central banks to burst bubbles; attempting to “Lean Against The Wind (LATW) (Wadhwani, 2008)” on rising asset bubbles to prevent a bigger burst. This perspective was widely accepted by central banks around the world.
There are mainly four arguments against LATW monetary policy. First, bubbles are difficult to predict; the market would likely detect asset bubbles before regulators would and the market would be able to orderly deflate those bubbles through natural market processes. Secondly, there is evidence that raising interest rates (a central bank strategy for determent) doesn’t reduce the inflation of bubbles since investors are likely to take the risk on high interest rate assets in the midst of an asset bubble based on the expectation of high returns on those assets. Third, the Fed is incapable of isolating dangerous asset bubbles from normal rising asset prices; monetary policy could ham-handedly attempt to prevent asset bubbles but have the effect of harming normal asset prices. Lastly, proactively bursting asset bubbles could make the burst harsher than if the bubble were allowed to burst on its own.
Those cautions have kept the Greenspan Doctrine in place since the late 80’s, but in the aftermath of the 2007 – 2008 crisis, many economists are beginning to wonder if the “lean” strategy may actually be cleaner than the Greenspan Doctrine. Not to mention, the Greenspan Doctrine assumed that bubbles could not be as destructive as the most recent housing bubble. Could central banks develop monetary policy strategies that are more precise in detecting and deterring asset bubbles?
Combating Price Bubbles
Clearly, setting aside the lean versus clean debate, there are standard monetary principles that have not always been followed or enforced. Namely, regulators should demand more transparent disclosure, require more capital and liquidity, apply stricter monitoring of risk, stronger enforcement of compliance, and more accountability for regulators charged with overseeing the financial stability of markets. These policies need to be either reinstated and or reinforced to help stabilize the markets during asset bubbles or otherwise.
But for central banks to devise better strategies for combating bubble driven asset pricing, it is necessary to rethink the Greenspan Doctrine considering how ill-prepared the central banks were for dealing with the crisis in the financial markets. Or, perhaps both strategies have a time and place in setting monetary policy. Frederic Mishkin argues that there is a way to apply the LATW strategy to the financial markets if first central banks understand that there are two different types of bubble driven assets and each one requires a different monetary strategy.
Asset-pricing bubbles are divided into “credit bubbles” – like the housing bubble – and “irrational exuberance bubbles” – like the dot-com bubble (Mishkin, 2011).” He argues that because credit bubbles are so destructive to the economy and so hard to clean up that it would be appropriate for central banks to focus their monetary policies on predicting and deflating credit bubbles before they grow too large. Credit bubbles are linked to the financial markets so intricately that whenever there is a credit bubble like the one just experienced, its bursting usually leaves in its wake a deep recession, a financial crisis and a long period of slow growth and high unemployment.
Unlike normal recessions, there was no sharp recovery after the last three big asset bubbles. Because it is so hard to recover from credit bubbles, trying to head them off and prevent them is necessary. The LATW can be applied and should factor in to central bank policy because credit bubbles are much easier to identify. Each credit bubble shares certain symptoms that could alert regulators to the problem: lower lending standards, premiums on risk become abnormally low and credit is being extended at a much faster and higher rate (Mishkin, 2011).
The central bank targets these credit bubbles by slowly raising interest rates to discourage excessive risk taking in the credit markets. By inflating the interest rates on these assets, central banks can tamp down exuberance as well as spark growth in a slowing economy (The Financial Times LTD, 2014). This requires central banks to turn their focus more sharply and aggressively towards monitoring and reacting to irregularities in asset pricing more than the traditional singular focus on controlling inflation (Wadhwani, 2008) (Gambacorta & Signoretti, 2013). Lastly, this type of proactive monetary policy could have the effect of reducing moral hazard through proactive responses to booms as opposed to the reactionary approach to booms after the bust; this could discourage the reckless risk taking that typifies credit bubbles (The Financial Times LTD, 2014).
While economists are still debating the merits of the LATW strategy of curtailing asset price bubbles, it is without question that the traditional standards of monetary oversight have been too lax over recent decades and reinforcing those policies will go a long way to restoring healthy checks and balances to the world market. However, it has also become very clear that these boom and bust cycles threaten financial stability in such a way that central banks can no longer ignore fluctuations in credit markets. While focusing on controlling inflation is still a target for central bank monetary policy, central banks must now focus efforts on developing Bubble Policies (Rudebusch, 2005) that can prevent or deflate asset price bubbles before they can do real damage to the economy
References
Brittan, S., Meltzer, A. H., Wolf, M., Smaghi, L. B., Schlesinger, H., Mayer, M. Frankel, J. (2009, Fall). Should, or Can, Central Banks Target Asset Prices? A Symposium of Views
Gambacorta, L., & Signoretti, F. M. (2013, July). Should monetary policy lean against the wind? – an analysis based on a DSGE model with banking.
Mishkin, F. S. (2011). How Should Central Banks Respond to Asset Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the GFC. Reserve Bank of Australia June Bulletin, 59-67.
Rudebusch, G. D. (2005, August 5). Monetary Policy and Asset Price Bubbles.
The Financial Times LTD. (2014, April 16). Definition of leaning against the wind. Retrieved from Financial Times Lexicon: http://lexicon.ft.com/term?term=leaning-against-the-wind
Wadhwani, S. (2008). Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, 25 – 34.
This blog post on asset price bubbles is incredibly insightful and timely. The thorough analysis of the causes and consequences of asset bubbles helps demystify a complex financial phenomenon. I particularly appreciated the historical examples, such as the dot-com bubble and the housing market crash, which highlight the recurring nature of these events. The discussion on the psychological factors driving investor behaviour and the role of market speculation adds depth to the topic. This article is a must-read for anyone interested in understanding how asset bubbles form and their potential impact on the economy. Excellent job in breaking down a complicated subject into an accessible and engaging read.
Your blog post on asset price bubbles is both informative and engaging. The breakdown of the stages of a bubble, from displacement to the inevitable crash, is very well articulated. The historical examples provided, such as the South Sea Bubble and the Great Recession, help illustrate the recurring patterns in financial markets. The discussion on the impact of monetary policy and regulatory oversight is particularly pertinent. This article does a great job of explaining a complex topic in a clear and accessible manner. It’s a valuable resource for anyone looking to understand the mechanics of asset price bubbles and their implications for the economy.
This article provides an excellent overview of asset price bubbles and their broader economic implications. The analysis of the factors leading to the creation and bursting of bubbles is thorough and well-explained. I especially liked the section on the regulatory challenges and the role of central banks in managing these bubbles. Your insights into the psychological aspects, such as investor overconfidence and the fear of missing out, are very relevant in today’s volatile market conditions. This post is highly educational and offers a balanced perspective on a topic that is critical for both investors and policymakers.
Thank you for this well-written and comprehensive post on asset price bubbles. As an economics student, I found the detailed examination of market dynamics and investor psychology particularly enlightening. The explanation of how irrational exuberance and herd behaviour contribute to the formation of bubbles is spot on. Your use of historical examples, such as the Tulip Mania and the 2008 financial crisis, provides valuable context and illustrates the repetitive nature of these phenomena. This article is an excellent resource for anyone looking to deepen their understanding of financial markets and the risks associated with speculative bubbles.