Addressing the Bubble in Asset Prices
25.01.2003
Annual Meeting 2003
The collapse of equity bubbles in Japan and the United States has put central bankers on the spot. Should they have moved more quickly to pop those bubbles, either by raising interest rates, restricting speculative lending, or both? Or would the cure have been worse than the disease, making the ensuring slumps worse?
Moderator Pamela D. Woodall, opened the session by noting that the growing importance of the global capital markets has left monetary authorities in a bind: Asset prices now have greater influence than ever on key macroeconomic variables, such as GDP growth and consumer spending, yet they are outside the direct control of central banks, unlike traditional monetary aggregates. This creates a potential policy disconnect. Consumer price inflation might be stable, even decelerating, yet rising asset prices might threaten severe economic dislocations down the road. How should they respond?
Robert James Shiller, Professor of Economics, Yale University, USA, said the rise of rational expectations theory - which holds that asset markets accurately reflect all available information - has made central bankers less willing to criticize speculative excesses than they were in an earlier, more judgmental, age. In reality, he argued, there is nothing in economic theory that holds markets are always correct. This is particularly true when speculators are constrained in their ability to bet against overvalued assets by selling them short. Under such conditions, Shiller observed, "you can get into a situation where all the experts are convinced there is a bubble, but nobody can do anything about it," except with the blunt instrument of monetary policy. Shiller’s conclusion: Central bankers should be willing to take action to pop bubbles - or better yet, prevent them from happening - but only under carefully defined circumstances.
As a top US Treasury official through most of the 1990s, Lawrence H. Summers, President, Harvard University, USA, might be held at least partly responsible for the failure of policy-makers to prevent a serious stock market bubble. Yet, Summers says his conscience is "relatively clear." At any number of Davos sessions during the bubble period, he said, he warned participants "the only thing we have to fear is lack of fear itself." Even now, he added, it’s not clear a "monetary assault" on the stock market would have produced a result any less destructive than what actually occurred. Summers compared pricking a bubble with higher interest rates to launching a pre-emptive attack against a dangerous enemy. Even if successful, such a strike can still have devastating side effects. "It takes enormous hubris to think you know when the right moment has come to start a war," Summers said. Central bankers should use other tools, such as margin lending requirements or public "jawboning," to combat speculative excess.
Otmar Issing, Member of the Executive Board and Chief Economist, European Central Bank, Frankfurt, said he agreed with Shiller that central bankers could and should be willing to identify bubbles when they form. This is not always difficult. It was obvious, Issing argued, that the rise in US stock prices during the late 1990s could not be sustained "unless corporate profits were going to grow to 100% of GDP." Nor do central bankers necessarily have to choose between traditional monetary indicators and a focus on asset prices. Every asset bubble in history, Issing contended, has been associated with a rapid expansion in money and credit. By heeding these warning signs, central bankers can at least prevent the monetary conditions most likely to breed bubbles.
The most vehement objection to basing monetary policy on asset prices came from Jacob A. Frenkel, Senior Vice-President and Chairman, Merrill Lynch International, United Kingdom. Frenkel said setting overt targets for asset values would "create the mother of all moral hazards." Knowing those targets, investors would react accordingly, creating major distortions in the capital markets - the very thing such a policy would be designed to prevent. "A central bank that chooses a certain outcome will also assume responsibility for that outcome - and will be held responsible for failing to achieve it," Frenkel warned.
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