ASSET PRICE BUBBLES

The most significant phenomenon in recent times in prolonged build up and sharp collapses in asset prices which we call asset price bubbles that tend to alternate between under valuation and

over valuation.

Asset price bubbles have a significant role in current subprime crisis. The momentous cause behind every major financial crisis like Japanese Liquidity Trap, Great Depression, and Dot.Com Crisis and so on is the formation and burst of asset price bubbles.

The main motivation for holding a speculative asset is the expectation that the price will continue to raise and hence asset price bubbles are permanent features of economic environment because of the nature of human behaviour.

The conventional view on this problem is that, monetary policy has very less to do with the asset price bubble formation and collapse considering its subjectivity. Also does central banks have to intervene in this issues is again a debatable question. Buying some arguments from research papers by Bank of International Settlements, Bernanke and Gertler (1999) conclude that “The inflation targeting approach dictates that central banks should adjust monetary policy actively and pre-emptively to offset incipient inflationary and deflationary pressures. Importantly for present purposes, it also implies that policy should not respond to changes in asset prices, except insofar as they signal changes in expected inflation.”

Against this, Cecchetti et al (2000) argue that “A central bank concerned with both hitting an inflation target at a given time horizon, and achieving as smooth a path as possible for inflation, is likely to achieve superior performance by adjusting its policy instruments not only to inflation (or its inflation forecast) and the output gap, but to asset prices as well. Typically modifying the policy framework in this way could also reduce output volatility. We emphasize that this conclusion is based on our view that reacting to asset prices in the normal course of policymaking will reduce the likelihood of asset price bubbles forming, thus reducing the risk of boom-bust investment cycles.” But having witnessed the recent subprime crisis, I would like to say that “It is central bank’s responsibility to control the heating up of asset price bubbles and should be able to find them out in early stages”

This leads us to one more interesting question; can asset price bubble be identified? US Supreme Court Justice Stewart view of macroeconomic asset price bubble “I could never succeed in defining them, but I know them when I see them”, to this BIS adds “when they see them, policy makers should be concerned” If crises are like accidents or natural calamities that happen or rare events that are beyond the realm of normal expectations, which Nassim Nichloas called them as Black Swan events, then there is nothing that can be done about it and we should take the after math effects. But even a crisis like subprime crisis has been predicted clearly by famous economists like Nouriel Roubini and hence he termed such an event as “White swan” in his famous book “Crisis Economics”. There may be a lot of subjectivity left in identifying bubbles, but it is not impossible to identify.

And hence we say though it is possible, but identifying bubbles is very difficult, even if they are identified, the growth of the bubble can be due to phenomenon of growth like credit growth, Industrialization, Demand growth etc…. Hence this arguments segregate this question into two more questions, are bubbles rational or irrational? Central banks have to curb irrational bubbles and not rational ones. Otherwise, it might hamper growth and might even push the system into more distress. Hence the instruments should be precise.

Probing into the reasons for bubbles that make them blow out of their fundamental values, in research paper “Asset Price Bubbles and Stock Market Interlink ages,” by Franklin Allen and Douglas Gale, authors have presented a theoretical model based on an “agency problem” of the amount of credit provided for speculative investment. Bubbles in capital markets and real estate emphasize the agency conflict that exists between borrowers and lenders when information is asymmetric. Risk is shifted if the ultimate providers of funds (banks) are unable to analyze their investments due to the lack of financial sector expertise and resulting opacity. The shifting of risk increases the return to investment in the assets and causes investors to bid up asset prices above their fundamental value.

The World Bank Group and the Federal Reserve Bank of Chicago cosponsored a conference on

Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies. I would

pick some statements that were made in this conference.

1) Though it is matter of serious concern, Central banks should not introduce asset prices into their monetary policy reaction function the reasons being, it is difficult to implement a sound monetary policy while focusing on highly volatile indicators and there are doubts whether asset prices can be determined scientifically.

2) Monetary policy is a blunt instrument for responding to a narrow class of asset markets. Therefore, the suppression of most asset price volatility through monetary policy is neither

feasible nor desirable.

Coming back to the square one, I would again like to reaffirm the statement; monetary policy is not the right instrument to curb “irrational asset price bubbles”. And having seen the repercussions of the crisis created by asset price bubbles, these are not something that can be ignored and left to the market to adjust to itself. Gone are the Old theories that say “market adjusts itself to demand and supply”. It is now central banks role to identify the bubbles and prick them in early stages and hence I would like to re-quote the question stated by Dr. Duvvuri Subbarao “What is the role of central banks in preventing asset price bubbles?”