Justin Lahart has a front-page article today on a group of economists studying bubbles at Princeton. It’s a perfectly interesting piece, marred only by relative weakness on the monetary-policy front. Given that the piece is illustrated with a dot portrait of Ben Bernanke, I wanted more than just this:
The Princeton squad argues that the Fed can and should try to restrain bubbles, rather than following former Chairman Alan Greenspan’s approach: watchful waiting while prices rise and then cleaning up the mess after a bubble bursts.
If the tech-stock collapse didn’t make that clear, the damage done by the housing and credit bubbles should, argues Jose Scheinkman, 60 years old, a theorist Mr. Bernanke recruited in 1999 from the University of Chicago. "Advanced economies are very dependent on the health of the financial system. What this bubble did was destroy the capacity of the financial system to finance the U.S. economy," Mr. Scheinkman says.
When a lot of borrowed money is involved — as it often is in a bubble — once prices peak, the speed of their fall is intensified as investors sell urgently to pay down debt. That pattern offers a strong argument, in Mr. Hong’s view, for government to restrain bubbles and the borrowing that fuels them.
Yes, the housing bubble involved a lot of borrowed money. But most other bubbles, not so much. Tech stocks? Commodities? Stocks in China? None of them are or were debt driven. Indeed, Rick Mishkin made exactly this point in his speech last night:
The bubble in technology stocks in the late 1990s was not fueled 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.
It’s a useful distinction to make: it can make perfect sense for central banks not to worry too much about asset bubbles, while still caring greatly about credit bubbles. And Mishkin’s clear that asset bubbles in and of themselves are no concern of the Fed’s:
To be clear, I think that in most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.
At the end of his speech, Mishkin even goes so far as to say that "central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good".
In recent days, there’s been a lot of speculation about whether the Fed might start looking more seriously at asset bubbles, most of it tied to a Krishna Guha article in the FT on Tuesday.
One option would be for the Fed to tackle bubbles with monetary policy, setting interest rates higher than they would otherwise be when asset prices appear to be inflating beyond levels justified by economic fundamentals.
Mr Bernanke rejected this approach in 2002 but is willing to re-evaluate it in the light of recent events.
In the light of Mishkin’s speech, I think any re-evaluation would still come out opposed to such a policy.