Saturday, March 14, 2009

Central Banks and asset bubbles

In a famous speech in Idaho in 2002 the then Fed Chairman Alan Greenspan had said that, "it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity - the very outcome we would be seeking to avoid. Prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy... we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact... the idea that the collapse of a bubble can be softened by pricking it in advance is almost surely an illusion".

But in light of the events of the past two decades, one of the greatest challenges for Central Bankers across the world will be to address asset bubbles as they get blown up. In other words, when and how to deflate such bubbles? Despite all the recent experience and the wealth of information and analysis, we are no closer to finding an answer to this problem. It is in this context that this address, pointed out by WSJ, given by John Kenneth Galbraith at the London School of Economics in June 1999 called "The Unfinished Business of the Century", assumes great significance,

"We have far more people selling derivatives, index funds and mutual funds (as we call them) than there is intelligence for the task. I am cautious about prediction; I discovered years ago that my correct predictions are forgotten, the others meticulously remembered. But some things are definite; when you hear it being said that we have entered a new economy of permanent prosperity with prices of financial instruments reflecting that happy fact, you should take cover. This has been the standard justification of speculative excess for several centuries - for a good part of the millennium. My one-time Harvard colleague Joseph Schumpeter thought inevitable and even beneficial what he called "creative destruction" - the cyclical process by which the system eliminates the people and institutions which are mentally too vulnerable for useful economic service. Unfortunately the process has larger and less benign effects, including the possibility of painful recession or depression."


Nouriel Roubini has been among those who have advocated Central Bank internvention to deflate buubles, and he has six arguments in support of his claim.

"1. Analytical models suggest that optimal monetary policy rules imply targeting of asset prices on top of inflation and growth in the monetary policy reaction function.

2. Optimal monetary policy should react to asset prices even when there is uncertainty about the existence and extent of an asset bubble.

3. Uncertainty as to whether bubbles affect the economy does not reverse the result that monetary policy should react to asset bubbles.

4. Monetary authorities should attempt to carefully "prick" a bubble.

5. A monetary policy that reacts to asset bubbles does not need to lead to severe economic contraction. It may instead appropriately control a bubble that may become damaging if left to grow without control.

6. It is inconsistent and non-optimal to argue that monetary policy should react to bursting bubbles but not to rising bubbles."


Greenspan too had clearly identified stock market bubble in 1996, when he made his famous "irrational exuberance" speech, and even had stated that he could absolutely deflate the bubble by raising the margin requirements on stock brokerage accounts. It therefore appears that the challenge is not so much Central Banks ability to spot bubbles, but their willingness to take remedial action to attentuate the cycle and the right choice and extent of policy options. However, one can only hope that the bitter experiences of the serial bubbles of the last three decades have made them and governments across the world more acceptable to slowing down economic growth in an overheating market.

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