Frederic Mishkin at Financial Times:
There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no.
Are potential asset-price bubbles always dangerous? Asset-price bubbles can be separated into two categories. The first and dangerous category is one I call “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. Loans go sour, the deleveraging begins, demand for the assets declines further and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The resulting deleveraging depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. Indeed, this is what the recent crisis has been all about.
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fuelled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. Similarly, the bubble that burst in the stock market in 1987 did not put the financial system under great stress and the economy fared well in its aftermath.
Because the second category of bubble does not present the same dangers to the economy as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. Asset-price bubbles of this type are hard to identify: after the fact is easy, but beforehand is not. (If policymakers were that smart, why aren’t they rich?) Tightening monetary policy to restrain a bubble that does not materialise will lead to much weaker economic growth than is warranted. Monetary policymakers, just like doctors, need to take a Hippocratic Oath to “do no harm”.
Simon Johnson at Baseline Scenario:
In other words: keep monetary policy right where it is, and don’t worry about financial regulation.
The second view is much more skeptical that “benign” bubbles stay that way. Remember that most damaging bubbles – or debt-based over-exuberance, if you prefer – during the past 40 years have involved two elements.
- Borrowers in emerging markets (Latin America and Eastern Europe in the 1970s; Mexico in the early 1990s; Russia, Ukraine, East Asia, Brazil and many others in the early-mid 1990s; Eastern Europe in the 2000s).
- Citibank (and its descendants), i.e., a bank that was large and global before any other US institution was so inclined. Rather than bringing us the wonderful benefits of financial globalization, Citi has almost failed at least twice – and been rewarded for its incompetence with gold-plated bailouts at least four times.
Of course, other banks from other countries have become involved at various moments, but the point is that the lending organizations behind every bubble come from more “developed” financial markets – even when the origin of the capital flows is elsewhere (e.g., recycling oil surpluses in the 1970s). And the borrowers are always in places where the rules become lax during a boom – in this sense, the US became just like a classic emerging market after 2001 (and arguably earlier).
Phil Izzo at WSJ
Henry Blodget at Clusterstock:
A couple of points:
First, is Mishkin really so certain that this bubble is of the harmless variety? It seems to us the government is borrowing an awful lot of money to support it. So how is this bubble not debt-fueled?
Second, is Mishkin really so confident that these two flavors of bubble can be correctly identified while they’re happening? As we recall, at the peak of the last bubble in 2007, the Fed was not just not telling us what kind of bubble we were having. It was telling us we weren’t having any kind of bubble. So it’s hard to imagine that, next time, they’ll know not just that we’re having a bubble, but which kind it is.
And his argument, that policymakers are incapable of recognizing bubbles is silly. Investors and speculators (crudely speaking) have tougher stomachs than analysts (and presumably policy makers). You need to be willing to take losses and many people are not wired to do that. Being able and wiling to play in markets every day takes certain personal attributes that go beyond analytical ability. Bubbles are extreme events, they are less difficult to recognize than day-to-day investment picks.
Moreover, Mishkin offers a straw man: that the only way to stanch an asset bubble in a particular market is via monetary policy, which is a blunt instrument. Now it is true that the only tool readily available to the Fed now is monetary policy. But the Fed was lobbying to act as macroprudential regulator. It seems very peculiar that, in this post-bubble carnage, it has not done much of anything to generate thought (staff papers, for a starter) on the issue of what tools in addition to monetary policy authorities need to have at hand to be able to attack bubbles in specific, but significant, markets. For starters, you can restrict leverage, put limits on types of trading that might favor purely speculative momentum traders, etc (you’d need to look into particular mechanism peculiar to the relevant markets to devise a surgical intervention).
Mishkin’s arguments are absurd, except they reflect the Fed’s complete unwillingness to take on this task. It is much easier to offer the excuse that you are incapable (and talk yourself into it), than deal with the bigger issue: that pricking an asset bubble is unpopular.
UPDATE: Megan McArdle
