| Abstract: |
Central banks should not be in the business of trying to prick asset price
bubbles. Bubbles generally arise out of some combination of irrational
exuberance, technological jumps, and financial deregulation (with more of the
second in equity price bubbles and more of the third in real estate booms).
Accordingly, the connection between monetary conditions and the rise of
bubbles is rather tenuous, and anything short of inducing a recession by
tightening credit conditions prohibitively is unlikely to stem their rise.
Even if a central bank were willing to take that one-in-three or less shot at
cutting off a bubble, the cost-benefit analysis hardly justifies such
preemptive action. The macroeconomic harm from a bubble bursting is generally
a function of the financial system’s structure and stability—in modern
economies with satisfactory bank supervision, the transmission of a negative
shock from an asset price bust is relatively limited, as was seen in the
United States in 2002. However, where financial fragility does exist, as in
Japan in the 1990s, the costs of inducing a recession go up significantly, so
the relative disadvantages of monetary preemption over letting the bubble run
its course mount. In the end, there is no monetary substitute for financial
stability, and no market substitute for monetary ease during severe credit
crunch. These two realities imply that the central bank should not take asset
prices directly into account in monetary policymaking but should be anything
but laissez-faire in responding to sharp movements in inflation and output,
even if asset price swings are their source. |