Friday, May 16, 2008

Asset "Bubbles"

There has been quite a bit of discussion of asset bubbles and how to deal with them in the past few days, with front-page stories in both the Financial Times and the Wall Street Journal, and other follow-up pieces as well (see also an editorial in the FT, "The Great Asset Price Controversy"). I can hardly offer any great wisdom to this debate, never having set foot inside a central bank in my life. But let me offer one small piece of advice: when talking about how central banks should deal with asset bubbles, maybe we should drop the "bubble" metaphor. Bubbles can be burst with just a prick. This gives the impression that central banks can fight asset bubbles with something akin to a prick, and might cause central banks to look too hard such a policy tool, which may or may not exist. Exhibit A is this picture, which accompanied an article on asset bubbles in today's FT:

The most compelling argument against using interest rates to fight asset bubbles (i.e., leaning against the wind), is that interest rates are too blunt an instrument. According to Fed Governor Frederic Mishkin, it is "inappropriate to use the blunt instrument of interest-rate increases to prick bubbles." Or as Ben Bernanke put it, "One might as well try to perform brain surgery with a sledgehammer." But maybe popping asset bubbles isn't brain surgery; maybe it requires more than just a "prick." As the article in today's Wall Street Journal emphasized, asset bubbles are very hard to pop:
Manias can persist even though many smart people suspect a bubble, because no one of them has the firepower to successfully attack it. Only when skeptical investors act simultaneously -- a moment impossible to predict -- does the bubble pop. ... [I]nvestors who spot the bubble attack only if each is confident that other skeptics are on board. In work done with Mr. Abreu, Mr. Brunnermeier concluded that if all the rational investors could agree to bet against the bubble, they could make big profits. But if they can't coordinate, it's risky for any one of them to bet against a bubble. So it makes sense to ride it up and then get out quickly as soon as the bubble's existence becomes common knowledge.
Using the bubble metaphor may well be fostering a false illusion that central banks can pop asset bubbles with a policy tool akin to a prick, when in reality central banks need to bring out the blunt instruments. Personally, I think we need to be very, very careful in allowing the Fed to intervene in markets based solely on the Fed's perception of asset prices. That's a very dangerous proposition, and not one that I'm immediately head-over-heels in love with. Hindsight is 20/20, and in the aftermath of a bubble it's easy to say that central banks should have seen it coming. Witness the healthy debate over whether the current run-up in commodities is a bubble. What if it turns out to be a bubble, and we're already past the point where central banks needed to intervene? Think about that before you sign-off on giving central banks broad authority to pop asset bubbles.

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