Central banks are responsible for bubbles and crashes

Many central bankers have argued that they should not target (or try to influence) asset prices. The recent events show how shaky this argument is. The argument makes sense if the banking system is insulated from the asset markets. In that case a central bank can reasonably argue that asset bubbles and crashes are none of its business. It only affects the non-banking sector, and the central bank should not be concerned with the profits and losses of investors. (One could still make the point here that if these bubbles and crashes have macroeconomic effects, it should be the concern of the central bank. But reasonable people can disagree here). The problem that we have seen in the recent crisis is that the banking sectors were not at all insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets, and its subsequent crash. And since the banking system was heavily implicated the central banks were also heavily involved by the very fact that they provide an insurance to the banks in the form of the lender of last resort. One could argue that central banks should not provide this automatic insurance. Reality however ensures that central banks are forced to provide liquidity when a crisis erupts. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that’s when the balance sheet of the central bank will inevitably be affected. It is not reasonable for a central bank to argue that asset bubbles and crashes should not be a source of concern and therefore that it should not try to intervene when a bubble arises, when it knows that the bubble will have large implications for its future balance sheet, and its profits and losses. Such an argument is literally irresponsible. If a private company were to refuse to take action when it expects to make large losses in the future, its CEO would most likely be fired for irresponsible behaviour. So, what can be done about this? There are two ways to tackle the problem. The first one, is for the central bank to recognize that asset bubbles are a source of concern and that it should act upon the emergence of such a bubble. The argument, made popular by Alan Greenspan, that a bubble can never be recognized ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble during the late 1990s. And this is the case for most asset bubbles in history. A second way to solve the problem is to reform the supervision and regulation in such a way that the banking system is insulated from asset bubbles and crashes. This is not going to be easy though. The banking sector is at the center of the payments system. As a result, crashes in asset prices tend to disrupt the payment system and create systemic liquidity problems. Banks are almost always implicated when asset prices collapse, making it necessary for central banks to intervene. Creating “Chinese walls” between asset markets and the banking system is always going to be difficult even in the best of regulatory environments. Thus, even in an improved regulatory environment (which is urgently needed) the central banks’ responsibilities extend beyond the control of inflation. The responsibilities of a central bank that cares about its future balance sheet necessarily include the monitoring and the prevention of asset bubbles.

8 Responses to "Central banks are responsible for bubbles and crashes"

  1. Ulrich Fritsche   October 17, 2007 at 8:09 am

    Very good arguments. The non-neutrality in macroeconomics does not (only) stem from the labor market but more forcefully from the financial sector. This is a point largely forgotten in modern New Keynesian approaches to analyze monetary policy. The question, however, for me seems to be: Is is necessary to avoid any bubble possibility by restraining effective demand ex ante? Put it differently: What differentiates a possible bubble (disappointed expectations) from a bubble? We have an ex-post fallacy that now — everyone claims that he knew it advance that this and this was unavoidable: As you said: one had to be blind… But then a dozen of well-respected colleagues was flying blind over the last couple of years, isn’t it?

  2. cm   October 17, 2007 at 8:21 am

    “One had to be blind not to see the bubble in the US housing market, or the internet bubble during the late 1990s. And this is the case for most asset bubbles in history.”

    Not sure it is easy to agree with this statement. It is feasible to recognize a (possible) asset bubble when asset prices are already inflated quite a bit. It is a bit harder to identify the conditions that could lead to an asset bubble. Real estate bubbles have developed in very different environments (in terms of regulation for example).

    “Central banks’ responsibilities extend beyond the control of inflation. The responsibilities of a central bank that cares about its future balance sheet necessarily include the monitoring and the prevention of asset bubbles.”

    Hard to disagree.

  3. Flanders Fields   October 17, 2007 at 8:22 am

    Good points Paul, always nice to read your comments. Only, I was surprized to read your paper that there would be no relation between inflation/debt and M3. Besides this, keep on the good work.
    A friend also from flanders.

  4. christian   October 17, 2007 at 11:13 am

    This brings back a debate: Should
    Central Banks Target Asset Prices?

  5. christian   October 17, 2007 at 11:15 am

    Should Central Banks Target Asset Prices? (http://www.rgemonitor.com/168?cluster_id=7321)

  6. Anonymous   October 17, 2007 at 12:22 pm

    Paul, Should central banks target asset prices via monetary policy or should they target them via prudential regulation and supervision of the financial system?

  7. MJ   October 17, 2007 at 12:26 pm

    I think it all comes down to responsible lending. The responsible lender should take care in its lending criteria and demand proof of income, and equity from the borrower. While this may have denied some the opportunity for home purchase, the tightening credit conditions would have dampened the market and avoided the credit crunch.

  8. eparisi   October 17, 2007 at 12:57 pm

    MJ, I fully agree. After all, it is financial intermediaries’ raison d’etre to deal with adverse selection and moral hazard. As long as regulation ensures that lending standards remain justifiable, the central bank need not halt the entire economy because of one sector that may or may not be out of balance ex ante.