Stephen Cecchetti has written a wonderful paper explaining the financial bubbles. He has written the paper from a central banker’s perspective and adds the challenges it poses to the central banks.
He begins by suggesting the theory behind bubbles:
The criticism of the bubble view is based on the efficient markets logic that markets incorporate all available information and this automatically eliminates bubbles. But there are many circumstances under which the argument fails. The dynamic stories that we tell to explain market efficiency are based on the arbitrage. And when arbitrage fails, so does market efficiency. In fact, even if everyone knows that there is a bubble, there is a broad set of realistic circumstances under which arbitrageurs will not eliminate it.
To understand the importance of this line of reasoning, consider a bubble in the aggregate equity market that is certain to burst. Specifically, imagine that the bubble grows at 5 per cent each quarter, and has a 5 per cent probability of bursting each quarter. The existence of the bubble is common knowledge among the well-informed fund managers, but their naïve investors aren’t sure about it. Will the manager of an open-ended fund take a short position to profit from the bubble? The answer is almost surely no.
Infact, he would instead join the herd and make his return till the bubble bursts. And efficient market hypothesis fails (I think Fama/French should rephrase EMH and say markets are efficient over a medium to long term which they indeed are as various crisis point) . The same idea is also given by Marcus Brunnermeier who incidentally is a key member of Bernnake’s Bubble Laboratory.
Then he looks at empirical evidence on bubbles (there are plenty) and how it distorts other economic variables – consumption, investment, fiscal policy (taxes decline but difficult to reverse spending), commercial banks (value of collateraldeclines alongwith losses on loans), lofty forecasts etc.
I like his difference between property and equity bubbles. He says property bubble burst is more costly than equity. Further, equity market rise leads to an increase in wealth but it is not the same for housing.
Put another way, people own their homes to hedge the risk arising from potential changes in the price of purchasing housing services. They want to ensure that they can continue to live in the same size home. A rise in property prices means people are consuming more housing, not that they are wealthier.
This point is made by Willem Buiter as well.
How about policy reponse? He says 5 options suggested by policymakers:
1. Take them into account only insofar as they influence forecasts of future inflation.
2. Act only after the bubble bursts, reacting to the fallout of the bubble.
3. Lean against the bubble, raising interest rates in an attempt to keep it from enlarging.
4. Include housing prices directly in the price index that the central bank targets.
5. Look for regulatory solutions both to keep the bubble from developing and to reduce the impact of a crash should one occur.
(1) is made famous by Bernanke. (2) by Alan Greenspan (which is favored by Mishkin and Bernanke as well). Cecchetti favors 3rd view. For (4), he computes inflation including housing prices in UK and finds inflation to be much higher which would in turn have require a much tighter policy. For (5) he says:
As I have argued, interest rates are likely to be the wrong instrument for addressing the risks housing bubbles create. This means looking towards solutions that focus on the lending that propels the bubble. There are two possibilities. Either try to restrain the lenders through regulatory mechanisms or restrict the borrowers. The first would involve supervisory adjustments to riskbased capital requirements. This is likely to be both complex and ripe for evasion – banks could simply sell the loans to willing investors.
The alternative is to adjust borrower loan qualification requirements to the environment. For example, maximum loan-to-value ratio could depend on deviations in rent-to-sale price ratios from their lagged moving average (or on the rate of recent increase). Alternatively, income coverage tests could depend on long-term interest rates rather than short-term interest rates. Or, rather than rationing credit directly, we could design a tax on mortgages that had the same impact. There are many possibilities, and we need to explore them. Indeed we need to explore many ideas on this subject.
Related to this is the issue of financial market structure. Are primarily bank-based financial systems more prone to difficulties? Is it important to work to increase the importance of secondary financial markets, or, alternatively, move towards narrow banks? The problem with this is that financial innovation cuts both ways. By making it easier to trade risk, it means both that risk can go to those best equipped to bear it and to those willing to accumulate it. The latter can create externalities.I think he must have got his answer after this crisis. The nature of finance itself is risky. Labeling a system as bank based or market based does not help. We are all moving now to a bank-based system and nationalised banks at that (even though it may be temporary).