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Investment Analysis

Should the Central Bank burst asset bubbles


Jan 06, 2008

In 1996, Fed. Governor Alan Greenspan made his famous speech about Irrational Exuberance. Central bankers know by heart that their job is to promote price stability. But stability of what prices, asked Greenspan. Should central banks promote the stability of prices included in the flawed consumer price index, or also about the prices of assets such as stocks and real estate?

Throughout history, incidents when consumer-price inflation is stable but asset and stock prices are sky-rocketing. The rapid acceleration of stock and property price would later be identified as a bubble, usually after it already bursts. The bursts is commonly followed by recession, unemployment, bank crises, and a lot of hind sight of what should have been done to avoid all these trouble.

Several groups of intellectuals and academicians advocated that the central bank should not simply target consumer-price inflation. They argue that asset and equity hyperinflation is as disastrous as consumer-price hyperinflation. In some instances it is much worse. They say that there is a tendency that inflationary pressures from loose monetary policy are swept under the rug. Instead of leading to rapid consumer price inflation, the excess liquidity are concentrated to specific markets. Hence, the economy ends up with a stable over-all consumer prices but hyper inflated stock and property markets.

The Bank of International Settlements (BIS), the central bankers' bank, has been advocating for many years now that asset prices should be given more attention. They launched a project that monitors house and asset prices and other measures to check the financial stability of countries. Individual thinkers, academicians and central bank officials also voiced their concern for asset prices.

On the other hand, central banks are still cautious of specifically targeting markets. The reason is that they only have one very powerful tool, the interest rates. Dousing the fire in the housing market might submerge other markets or the entire economy under a tsunami. Another problem is that it is very difficult to spot a bubble. As stated above, bubbles are only recognized and verified only after they burst.

A similar concern is that the central bank is intended to concentrate on the overall price level. If it starts to focus on the stock and asset markets it might soon find itself meddling in all markets perceived to be threatening to price stability. Central banks are also not mandated to halt-asset price inflation. If it curbs asset and stock prices due to perceived threats to financial instability, it will soon earn the ire of politicians and 'concerned' stockholders and homeowners, ergo, voters. It would not be long before Congress would act to limit its powers.

Finally, other advocates that sometimes the best solution is to do nothing. History is full of stories about monetary and fiscal interventions that led to more harm than good. Bursting asset bubbles are desirable if and only if we know what we are really bursting.


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