August 28, 2002
Defending the Economy by Attacking Asset Prices?

I have always been of the school that central banks should watch asset price bubbles with alarm, but should not raise interest rates in order to try to prick them. My guiding principal has thus been: "Sufficient unto the day is the evil thereof." I suppose I have been most affected by the memory of the Great Depression, where the Fed's desire to restrain asset prices generated interest rate increases that played a role (how big a role is still in dispute) in starting the snowball that became the avalanche of the Great Depression.

Here Samuel Brittan cautiously, judiciously makes the case for a more aggressive policy toward asset price bubbles. I'm unconvinced, but it is certainly worth thinking about.


Samuel Brittan: Taking asset prices seriously:

...a regime of inflation targets alone has now come under criticism for a different reason. The fear now is not that real output has been neglected but that asset prices have been. There is a vigorous if rarefied debate about whether asset prices as well as consumer price inflation should be specifically targeted. The riposte of central bankers is that asset prices are in fact taken into account insofar as they are expected to contribute to future inflation. For instance, the property boom in the UK made some hawks on the Bank of England's monetary policy committee flirt with an interest rate increase this year. It has more recently been a factor delaying a cut. The deputy governor of the Swedish central bank has suggested that policymakers should deal with the aftermath of an asset price boom but should not attempt to pre-empt it. The critics argue, however, that this is not enough and action is needed to restrain an excessive rise in asset prices even if the inflation forecasts do not stray from the target range...

Samuel Brittan: Taking asset prices seriously
By Samuel Brittan
Published: August 28 2002 19:58 | Last Updated: August 28 2002 19:58

Inflation targets have now been in use for about 10 years in many countries. The pioneer was probably New Zealand, followed not long afterwards by the UK. They have had a greater success than many people expected in keeping the inflation rate low while also reducing fluctuations in real growth. But rules for monetary policy in a paper currency world are not cast in stone. What was sufficient for the last decade may not be enough in the future.

The main original fear about inflation targets was that they would be achieved at the expense of growth and employment. That was one reason why some observers, myself included, would have preferred an objective that explicitly included a growth element, such as for nominal gross domestic product growth.

 

 

 

 

 

 

 

 

In fact, a regime of inflation targets alone has now come under criticism for a different reason. The fear now is not that real output has been neglected but that asset prices have been. There is a vigorous if rarefied debate about whether asset prices as well as consumer price inflation should be specifically targeted.

The riposte of central bankers is that asset prices are in fact taken into account insofar as they are expected to contribute to future inflation. For instance, the property boom in the UK made some hawks on the Bank of England's monetary policy committee flirt with an interest rate increase this year. It has more recently been a factor delaying a cut.

The deputy governor of the Swedish central bank has suggested that policymakers should deal with the aftermath of an asset price boom but should not attempt to pre-empt it.

The critics argue, however, that this is not enough and action is needed to restrain an excessive rise in asset prices even if the inflation forecasts do not stray from the target range.

One of the more moderate statements of the case is made by Michael Bordo and Olivier Jeanne in a paper for the Centre for Economic Policy Research*. Inflation, they argue, is not the only danger from an unchecked boom in asset prices. Such a boom carries with it the risk of a bust that will destroy the value of securities held by financial institutions and thus induce "a collateral- induced credit crunch".

In their view the case for monetary restriction is greatest when the risk of a bust is large but when it can still be defused at relatively low cost. This means not delaying too long, as Alan Greenspan, chairman of the US Federal Reserve, did in the late 1990s. For, as the boom gathers momentum, more severe monetary restriction is required to puncture it. Central banks may then find themselves in the paradoxical position of having to induce a recession now to forestall the risk of a more severe recession when the bubble bursts.

To the ordinary person it seems odd to talk of low inflation when property prices are going through the roof and newlyweds cannot get their foot on the housing ladder. As Harvey Cole, an economic consultant, says: "For those who doubt that asset bubbles are dangerously inflationary, the proof is simple. Does anyone deny that their bursting must be expected to have serious deflationary consequences?"

Bordo and Jeanne cite as their two main examples of a big stock exchange-induced boom-bust cycle the US depression of 1929-33 and the Japanese one of 1986-1995. They agree with Milton Friedman that the depth and length of the depression were due to banking panics, which led to a collapse in the money supply.

But the Wall Street crash contributed to this monetary contraction by reducing the value of bank loans and collateral. This led to a collapse of bank lending and the dumping of loans and securities, creating further asset price deflation.

They argue that if the Fed had followed the views of Benjamin Strong, its chairman, and defused the stock market boom in 1928, the outcome would have been very different; and they conjecture the same for Japan in the late 1980s.

The authors admit that assessing an asset price bubble is easier said than done. But is it, they ask quite reasonably, any more difficult than estimating the so-called output gap - how far output is from capacity levels - on which the interpretation of the current inflation target rules so often depends?

A Bank for International Settlements study** argues, with an eloquence rare in such research papers, that it is not asset prices themselves that pose a threat to the stability of the financial system but the combination of rapid credit growth, rapid increases in asset prices and, sometimes, high levels of physical investment. In any case, their charts show that for many countries there is a strong link between asset price growth and the growth of private credit.

The biggest policy problems relate to property prices. Bordo and Jeanne examine in detail experiences of Organisation of Economic Co-operation and Development countries since 1970. They find that out of 24 boom episodes in equity prices only three were followed by busts: Finland in 1988, Japan in 1989 and Spain in 1998. On the other hand they diagnose 19 booms in property prices in which 10 were followed by busts (two of which occurred in the UK in 1973 and 1989).

Property price bubbles tend to be localised. This suggests that central bank policy may not be the best way to deal with them in monetary areas as large as the eurozone or the US - or possibly even the UK.

Mr Cole suggests decoupling mortgage rates from the rest of the market. But such segregation is difficult in a free economy. He advocates requiring all institutions lending on property to place variable special deposits with the Bank of England.

Such a scheme for the commercial banks, which existed in the 1970s, was wound up because it introduced distortions without being very effective. Nevertheless, unless anyone suggests something more refined, we could well see a return to such methods.

In any case, policymakers will have to move on from targets aimed at inflation alone. The implicit model behind these targets is that all economic ills are reflected in inflation rates that are too high or too low - or are changing too rapidly or too slowly - and that, therefore, if these can be kept within sensible bounds all other ills will cure themselves.

If a war with Iraq sends the oil price soaring, so that we once again witness that combination of inflation and recession known as stagflation, the model will be tested to breaking point.

*Discussion paper 3398, May 2002*

*BIS working paper 114, by C. Borio and P. Lowe, July 2002

Requires subscription = requires
Posted by DeLong at August 28, 2002 09:17 PM | Trackback

Email this entry
Email a link to this entry to:


Your email address:


Message (optional):


Comments

No it isn't. All of the problems of "asset bubbles" referred to are actually examples of over-lent and undercapitalised financial systems. A few minutes thought about the policy objects and policy instruments debate should convince one that the proper solution to a banking system which is becoming over-exposed to inflated asset prices is unlikely to be to bugger about with the interest rate for the whole economy; that's surely what financial regulators are *for*.

This is potentially an argument for Greenspan raising margin requirements in 1996 (I personally think it's pretty weak even for that), but not for raising interest rates.

I seem to remember that Sam Brittan has a blind spot when it comes to asset bubbles; he's always trying to think of a rationale for bursting them. Back in 1997-8, I think he wrote a series of articles from him pushing Kenneth Arrow's argument that the Dow and Nasdaq represented the prices of claims on future goods and services and were thus properly regarded as part of today's inflation.

Posted by: Daniel Davies on August 28, 2002 11:19 PM

Japan's central bank was quite pleased about piercing the asset bubble in 1990 and 1991 and 1992 and 1993.... Dangerous stuff.

Worry about an asset bubble in housing may restrain the Fed when rates may need lowering.

If Japan does serve for a recent example, I say let the Fed worry about general inflation. The Fed will play it too fine worrying about stock and housing prices as well.

Posted by: on August 29, 2002 09:44 AM

It would be interesting to know whether the Fed raised rates by 50 basis points in May 2000 to slow the economy over concern about inflation or to bring down stock prices. That final interest rate increase never made sense to me.

Posted by: on August 29, 2002 10:50 AM

Indeed. I also always thought that the Fed had overdone it. The Fed did did slow down the financial markets, it jumped on the breaks...

Perhaps instead of piercing bubles central banks should hold the stock market more or less in place until the value of earnings catches up with equity price (up to a certain ratio, of course.)

Posted by: Jean-Philippe Stijns on August 29, 2002 01:26 PM

So asset prices should be restrained, because even if they don't show in the inflation number they somehow cause inflation? I'm missing something here.

Posted by: Jason McCullough on August 30, 2002 10:08 AM

attempted restraint of asset prices seems to smack of turning macro authorities to micro managers - the point is to allow the markets to self-correct and protect the broad economy against adverse effects during the correction - who was to say at what point the equity bubble should have been popped? - who was to assure a gentle cooling? - sorry - too complex

Posted by: on August 30, 2002 11:02 AM

Jason: Arrow's argument was not that asset price rises *cause* inflation but that they *are* inflation. If the price of MSFT goes up, then that's telling us that the notional price today of Windows 2010 will be higher. And since Arrow's big thing is the Arrow-Debreu market completeness concept, "the notional price today of Windows 2010" is a good for him, same as a pound of spuds.

Posted by: Daniel Davies on August 30, 2002 12:51 PM

'If the price of MSFT goes up, then that's telling us that the notional price today of Windows 2010 will be higher.'

Ok, so if MSFT doubles over a year with no changes in actual expected future revenues than that's a 100% increase in the "price" you need to pay to lay claim to MSFT future earnings.

Ah, so it's kind of "inflation of investment goods"? It's not in the GDP deflator or CPI, I guess.

I'm not sure how useful it'd be though, as "investment inflation" went absolutely haywire while "consumption inflation" stayed pretty flat. God knows how you'd get a good measure of it.....

Posted by: Jason McCullough on August 30, 2002 01:37 PM
Post a comment
Name:


Email Address:


URL:


Comments:


Remember info?