Paul De Grauwe: "Central banks should prick asset bubbles"

Paul De Grauwe, professor of economics at the University of Leuven, makes a persuasive and succinct case as to why central banks need to combat asset bubbles. Reading his argument, one might even wonder why the topic is controversial.

Yet it is. Beyond insuring the safety of the banking system, central bankers’ mandates extend only to the real economy: promoting growth and containing inflation. For example, a January post quotes Fed governor Frederick Mishkin arguing that “this concern about burst bubbles may be overstated” and that central bankers cannot identify bubbles in the making.

One might argue, as De Grauwe does, that protecting the financial system requires the regulatory authorities to worry about asset price inflation. That viewpoint, however, has never been widely accepted, in aprt because moderate asset inflation makes everyone feel richer.

A former central banker, Australia’s Ian Macfarlane, explains the conumdrum that heretofore constrained even those central bankers who recognized the dangers of runaway asset prices:

The biggest single challenge starts with the recognition that as an economy becomes more developed, its financial side grows a lot faster than its real side. As a result, economic outcomes will depend more on what happens in asset markets and less on what happens in the real side of the economy, such as in the goods and labour markets….If a major financial shock were to occur, such as a large fall in share or property prices, the effect on the economy would be greater than before.

So the central question is whether booms and busts in asset markets are more likely to occur in the future. No one knows, but there is no reason to believe that they will become less frequent or smaller….

If it is likely that asset price booms and busts will be at least as common as over the past two decades and that their effect on the economy will be larger, what can monetary policy do about it? There was a time when we felt that monetary policy, by returning the economy to low inflation, would have a stabilising effect on asset markets…. But the broader evidence does not support the view that low inflation will prevent booms and busts developing in asset markets….Some have even gone as far as to suggest that low inflation may encourage the build-up in asset prices.

So, if low inflation does not provide any insurance, what should a central bank do if it suspects that a potentially unsustainable asset price boom is forming, particularly when the boom is being financed by debt?…

Many people have pointed out that it is difficult to identify a bubble in its early stages, and this is true. But even if we can identify an emerging bubble, it may still be extremely difficult for a central bank to act against it for two reasons.

First, monetary policy is a very blunt instrument. When interest rates are raised to address an asset price boom in one sector, such as house prices, the whole economy is affected. If confidence is especially high in the booming sector, it may not be much affected at first by the higher interest rates, but the rest of the economy may be.

Second, there is a bigger issue which concerns the mandate that central banks have been given. There is now widespread acceptance that central banks have been delegated the task of preventing a resurgence in inflation, but nowhere, to my knowledge, have they been delegated the task of preventing large rises in asset prices, which many people would view as rises in the community’s wealth. Thus, if they were to take on this additional role, they would face a formidable task in convincing the public of the need.

Even if the central bank was confident that a destabilising bubble was forming, and that its bursting would be extremely damaging, the community would not necessarily know that this was in prospect, and could not know until the whole episode had been allowed to play itself out. If the central bank went ahead and raised interest rates, it would be accused of risking a recession to avoid something that it was worried about, but the community was not. If in the most favourable case, the central bank raised interest rates by a modest amount and prevented the bubble from expanding to a dangerous level, and it did so at a relatively small cost in terms of income and employment growth forgone, would it get any thanks? Almost certainly not…In all probability, the episode would be regarded by the public as an error of monetary policy because what might have happened could never be observed….

Looking back at the evolution of monetary and financial affairs over the past century shows that policy frameworks have had to be adjusted when they failed to cope with the emergence of a significant problem. The new framework then is pushed to its limits, resulting in a new economic problem. The lightly regulated framework of the first two decades of the 20th century was discredited by the Depression and was replaced by a heavily regulated one accompanied by discretionary fiscal and monetary policy. This in turn was discredited by the great inflation of the 1970s and was replaced by a lightly regulated one with greater emphasis on medium-term anti-inflationary monetary policy….

No one has a clear mandate at the moment to deal with the threat of major financial instability, but I cannot help but feel that the threat from that source is greater than the threat from inflation, deflation, the balance of payments and the other familiar economic variables we have confronted in the past.

Observe what a difference a few months of deleveraging-induced pain makes. The conseqences of ignoring asseet bubbles now seems so self-evident as to demand action.

From the Financial Times:

The credit crisis that hit the world economy in August teaches us many lessons about the workings of integrated financial markets. It also teaches us something about the responsibilities of central banks.

Until the crisis, the consensus view was that central banks should target inflation and that is pretty much all they should do. In this view, central banks should not target (or try to influence) asset prices either, as was stressed by the former Federal Reserve chairman Alan Greenspan, because central banks cannot recognise bubbles ex ante. Or, if they can, the macro economic consequences of bubbles and crashes are limited as long as central banks keep inflation on track. Inflation targeting, we were told, is the new best practice for central bankers that makes it unnecessary for them to try to influence asset prices.

The credit crisis has unveiled the fallacy of this hands-off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector and a central bank is not in the business of insuring private portfolios.

The problem that we have seen in the recent crisis is that the banking sectors were not insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. Since the banking system was implicated, the central banks were also heavily involved owing to the fact that they provide insurance to the banks as lender of last resort. Some may wish that central banks would abstain from supplying this insurance. However, central banks are forced to provide liquidity during a crisis because they are the only institutions capable of doing so. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected.

There is a second reason that the hands-off approach has been shown to be wanting. During the past few years, a significant part of liquidity and credit creation has occurred outside the banking system. Hedge funds and special conduits have been borrowing short and lending long and, as a result, have created credit and liquidity on a massive scale. As long as this liquidity creation was not affecting banks, it was not a source of concern for the central bank. However, banks were heavily implicated. Thus, the central bank was implicitly extending its liquidity insurance to institutions outside the regulatory framework. It is unreasonable for a central bank to insure activities of agents over which it has no super vision, just as it would be unreasonable for an insurance company selling fire insurance not to check whether the insured persons take sufficient precautions against the outbreak of fire.

So, what should central banks do besides target inflation? First, central banks should recognise that asset bubbles are a source of concern and that they should act on the emergence of such a bubble. The argument that a bubble can never be recognised ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble. This is the case for most asset bubbles in history.

It has been argued that even if central banks can detect bubbles, they are pretty much powerless to stop them. This argument is unconvincing. It is not inherently more difficult to stop asset bubbles than it is to stop in flation. Central banks have been highly successful at stopping inflation.

Second, central banks should be involved in the supervision and regulation of all institutions that create credit and liquidity. The UK approach of dissociating monetary policy from banking supervision has not worked. Central banks are the only insurers against liquidity risks. Therefore they are the ones who should control those who create credit and liquidity. Failure to do so will continue to induce agents to create excessive amounts of liquidity, endangering the financial system.

The fashionable inflation-targeting view is a minimalist view of the responsibilities of a central bank. The central bank cannot avoid taking more responsibilities beyond inflation targeting. These include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.