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Should central bankers actively
undertake to burst asset bubbles, or should they stand around and watch them
run out of steam, then try to clean up the mess by cutting interest rates?
This has been the subject of a recent round of debate between central bank
economists and other interest macro thinkers:
·
Greenspan
Fans at Jackson Hole May Differ on View of Bubbles
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Danger
time for America: The economy that Alan Greenspan is about to hand over is in
a much less healthy state than is popularly assumed
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Analysis:
Burst bubbles - pyramid schemes
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Remarks
by President Geithner: Some Perspectives on U.S. Monetary Policy
The problem with the entire discussion is that it
assumes that asset bubbles "just happen", or they are a result of
some pathologies of investor behavior. The discussion takes bubbles as an
exogenous event, basically a pathology of irrational market pricing.
One side of the debate believes
that central banker has the ability to correct pathologies of market pricing,
while the other side expresses skepticism about whether asset bubbles can
event be identified. After all, if markets are efficient, then perhaps
stocks, or homes, really are worth several multiples of what they cost
a few years before.
The discussion ignores the
pivotal role of central banks in creating asset bubbles. They do this by
fixing interest rates at a level below the market rate -- the rate at which
saving and investment would be equal -- and holding the rate there.
If interest rates were set by
the market, an increased demand for investable funds would eventually have to
result in a rise in interest rates because people only have so much present
income out of which to save. The greater the demand for investable funds, the
more people would have to be offered to part with increasingly scarce
savings. The rise in interest rates would eventually limit the amount of
funds that could be used to drive up asset prices.
During the stock buble of the
90s, one often heard that stocks were cheap in relation to bonds because bond
yields were low. The so-called "Fed Model" considers stocks to be
cheap if the earnings yield on stocks is less than the yield on 10-year
treasury bonds. During the last five years of real estate bubble, many
analysts have said that homes were not overpriced "given the level of
interest rates". Any good that has a long time component in its
valuation, whether investment (stocks) or consumption (homes) can be made to
look cheap at a sufficiently low level of interest rates.
Robert Blumen
Robert Blumen is an independent
software developer based in San Francisco, California
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