Wednesday, November 14, 2007

Targeting Asset Price Bubbles

Paul De Grawe at the Vox EU blog points out that consumer price inflation isn't the only peril, and that asset price bubbles are worrisome too. Which is good, although the picture he gives of central banks somehow being independent of this is misleading, as central banks even though they may not have undertaken active steps to create it -although they sometimes do that too, the Fed's action in 2001-04 was a good example of this- they are still responsible by preventing interest rates from rising when speculative demand from credit rises.

He also points out that the various arguments that various Fed officials, such as Alan Greenspan, Ben Bernanke and Frederic Mishkin, have used against preventing asset price bubbles, or more correctly abstaining from accomodating them, is nonsensical.

First that it is impossible to detect asset price bubbles, since detecting them assume that Fed officials are smarter than the markets as the markets if they realized it was a bubble would have already ended the bubble. But as De Grawe points out, it should be obvious that double digit credit growth combined with double digit asset price increase is a sign of a bubble. And here I could add that it is often the case that it is rational for investors to participate in something they know is a bubble if the bubble seem likely to get bigger still, and if they know central banks will bail them out and limit their losses if they sell too late.

The second argument is that it is somehow impossible to burst asset price bubbles. Which makes even less sense as it is in fact the case that monetary policy has a stronger effect on asset prices than consumer prices. Try raising the Fed funds rate from 4.5% to 6.5% at the next meeting and have Congress institute a law preventing it from being reduced in the coming 24 months. I think we can be certain that stock prices would fall far more than consumer prices on that news, particularly in the short term.


Blogger flute said...

Thanks, Stefan, for the laugh of the day! Your last paragraph about how to burst an asset bubble was brilliant.

11:28 PM  

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