Asset price bubbles: how they build up and how to prevent them?

A nice review of issues by Gertrude Tumpel-Gugerell of ECB.  He looks at two issues on asset prices and bubbles:

  • Why do asset price bubbles arise and why are they so dangerous for the health and stability of the financial system
  • What can policy do about asset price bubbles?

He says asset bubbles are all around us:

It is not very hard to find recent examples of asset price bubbles. Chart 1 shows the evolution of real home prices in the United States and Ireland since 1990. Both economies show a sharp increase in home prices between 1995 and 2005. In Ireland prices more than tripled; in the US they rose by 70%. As we know today, these price appreciations ultimately proved unsustainable and in both countries, the housing market has fallen by a third since 2007.

Such boom-bust cycles in housing prices are by no means only a feature of the recent past. The Scandinavian economies went through a housing bubble of their own in the 1985-1995 period. As Chart 2 clearly shows, real estate prices rose and fell dramatically. In the cases illustrated in the two charts the housing bubble led subsequently to a financial crisis accompanied by a deep recession. More generally, economic historians – such as Charles Kindleberger [1] and others, have provided evidence that financial systems have a tendency to generate such financial boom-bust cycles, which sometimes take systemic dimensions that can cause or contribute to severe financial crises and recessions.

In India, the housing prices in key cities has increased at a faster pace than US and Ireland (and even Spain). But the policymakers still say there is no bubble.

Anyways, he says though it is easy to say there  was a bubble after it bursts but very difficult to know before hand that there is a bubble. But one clearly knows that bursting of the bubble is very bad for the economy. There are two kinds of policies to counteract bubbles:

  • Ex post (cure after the fallout): This was the consensus before the crisis i.e. mop up the effects after the crisis. This worked earlier as recessions were shallow. Not this time as fiscal deficits have ballooned and many issues have cropped up
  • Ex Ante (prevent before the fallout): The in thing right now trying to prevent the a crash. Include macroprudential policies etc.

Then comes the age old question – Should central banks be responsible for managing asset bubbles? Not via interest rates but it can via its monetary variables as ECB has been doing:

The importance of monetary policy for financial bubbles and imbalances has been underscored by growing empirical evidence [10] that holding interest rates too low for too long is likely to lead to declining lending standards and growing risk-taking in the banking system. This is associated with significantly higher defaults over time.

Moreover, we have seen that the materialization of systemic risk and financial instabilities can lead to deep recessions associated with great economic costs, which in turn, carries risks for medium term price stability.

The ECB is tasked with ensuring price stability in the medium term for the citizens of the Euro area. It is unique amongst central banks in having a two pillar approach which combines both economic and monetary analysis in order to arrive at the appropriate interest rate setting.

To the extent that financial imbalances are accompanied by excessive monetary and credit growth, the ECB’s focus on medium term definitions of price stability as well as its use of the monetary pillar already provides some ‘leaning against the wind’. Work at the ECB [11] shows that the leaning against the wind attitude embedded in the ECB’s monetary analysis has contributed to containing the build-up of financial imbalances prior to the financial crisis. As a result, it has prevented a more significant fall out in economic activity during the crisis and larger risks to price stability. Therefore, this analysis shows that a cautious leaning against excessive money and credit growth and building financial imbalances as part of the monetary pillar can bring benefits not only for financial stability but also for price stability.

The speech has some useful references as well…Nice round up of issues..

3 Responses to “Asset price bubbles: how they build up and how to prevent them?”

  1. pravin Says:

    this is playing like a broken record from a broken paradigm.monetarist and keynesians were never able to see the bubble.they have no theory of capital at all.for them all money is one big M in whatever nifty equation they want to plug and chug into.
    kindelberger is ok.but he also invokes the silly animal spirits canard.hayek explained why central planning cant work -because of the calculation,coordination and knowledge problems.cental banking is nothing but central economic planning with all the attendent moral hazards when it is in bed with wall st.
    economists like yourselves owe it to your morals to study hayekian and misesian economics.the austrian economists clearly forecast the bubble.or atleast you need to familiarise yourself with its theory of capital and structures of production.
    output gap ,liquidity trap and slack are folk is funny who nobel winners keep harping on such vulgar keynesianism

    • Amol Agrawal Says:

      I wouldnt fully buy this arguement. Some economists did argue quite well how we are sitting on a crisis waiting to happen. Though I would agree that most central bankers/policymakers never bought the ideas and believed too much in the power of financial sector and efficient markets. I would guess we need t o understand all the different perspectives including Austrian economics. No one theory is fully right. There are limitations in all the broad economic theories

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    Asset price bubbles: how they build up and how to prevent them? « Mostly Economics…

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