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Chicago Fed- What Are Asset Bubbles

Chicago Fed- What Are Asset Bubbles

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Asset price bubbles: What are the causes, consequences, andpublic policy options?
by Douglas D. Evano, vice president and senior research advisor, George G. Kauman, proessor, Loyola University Chicago,Quinlan School o Business, and Anastasios G. Malliaris, proessor, Loyola University Chicago, Quinlan School o Business 
This article discusses how the global financial crisis has forced researchers and policymakersto reconsider their understanding of both the economics of asset price bubbles and alternativepolicy options to address them.
Chicago Fed Letter
Economists and policymakershave begun to reevaluate whatthey really know about assetbubbles and whether theycan (or should) be managedin the public interest.
price bubbles have generated sig-nicant interest, since there have beeninstances when their bursting has led toturmoil in nancial markets and the wider economy. The October 99 stockmarket crash is perhaps the most dramaticinstance. That said, until recently, thesuccessul perormance o the U.S. econ-omy in the post-World War II era, partic-ularly during the “Great Moderation”o 984–006, appeared to provide botheconomists and policymakers with con-dence that there was little need or pub-lic policy to manage such bubbles. Forexample, the October 987 stock market crash had little impact on the real econ-omy, and the bursting o the Internet bubble in 000 resulted only in a short and mild recession by historical standards.However, the global nancial crisis o 007–09, induced in large part by acrashing o the housing market, had asignicant adverse impact on both theU.S. and global economies. As a result,economists and policymakers have be-gun to reevaluate what they really know about asset bubbles and whether they can (or should) be managed in thepublic interest.
To advance our knowledge o asset bubbles, Loyola University Chicago hosteda conerence in April 0. Papers werecommissioned rom experts to reexaminea number o seminal articles on asset bubbles written beore the crisis. Theultimate objective was to challenge or-thodox thinking on bubbles in light o recent events.Subsequently, ve seminal papers onasset bubbles, ve papers commissionedto evaluate and update these infuential works, and additional related research were published in a book titled
New Perspectives on Asset Price Bubbles 
Theremainder o this article provides asummary o the analyses o bubbles inthat volume.
What are asset bubbles?
In general, according to current economictheory, a bubble exists when the market price o an asset exceeds its price deter-mined by undamental actors by a sig-nicant amount or a prolonged period.The ecient market hypothesis assertsthat extraordinary movements in asset prices are a consequence o signicant changes in inormation about unda-mentals. Thus, actual and undamentalprices are always the same, and bubblescannot exist unless they are driven by irrational behavior or market rigidities,such as constraints on the short sellingo assets. In a seminal article (rst pub-lished in 99), Franklin Allen and Gary Gorton examine this critical question: Are stock prices determined by economicundamentals, or can bubbles exist?
History shows us that asset bubbles occur and that theirbursting can be detrimental to the macroeconomy.
They careully develop a detailed theo-retical model and show that the existenceo bubbles can be consistent with rationalbehavior. This result was not ully appre-ciated at the time by either economistsor central bankers, who oten were skep-tical about the existence o bubbles. Ina review o Allen and Gorton’s paper,Gadi Barlevy discusses the current stateo theoretical models o asset bubbles.He expresses disappointment with thegap between the theoretical work onasset bubbles and the post-crisis changein views about the appropriate policy response among some policymakers (i.e.,to intervene). Little in the theoreticalliterature supports the contention that intervention is appropriate. Yet empiricalevidence suggests that the potential costso bubbles may be signicant. Barlevy concludes that theoretical models o bubbles have not adequately addressed welare considerations and thus are un-able to oer convincing analytical guid-ance to central banks as to whether aneconomy will be better o rom attemptsto manage asset bubbles.
Causes and consequences
 Among the various types o asset bubbles,stock market and housing bubbles arehistorically o most interest to centralbanks, since such bubbles have beenassociated with the greatest adverseeects.
However, beore the event, it isdicult to predict i a stock market orhousing bubble will grow until it abruptly bursts or i it will develop and then quietly defate on its own without much macro-economic impact. It is still too early toully evaluate the real economic costs o the recent bursting o the U.S. housingmarket bubble and the accompanyingsignicant decline in stock prices; yet theevidence rom Japan is not encouraging.In a seminal article (rst published in000), Takeo Hoshi and Anil Kashyapdiscuss in detail the Japanese bankingcrisis that prevailed or most o the 990s,ollowing the bursting o bubbles inboth the Japanese stock and real estatemarkets. Andrew Filardo agrees withHoshi and Kashyap’s assessment o the Japanese crisis, and argues that the spill-overs rom the recent nancial crisis tothe Asia-Pacic real economies presenteddaunting policy challenges or centralbankers in the region. Globalization hasopened up potentially signicant interna-tional transmission channels. As a result,the rules o the game have changed, anddetermining optimal monetary policy isnow much more dicult. Filardo un-derscores a larger point that the globalnancial system needs to be signicantly strengthened. Regulatory groups cur-rently evaluating policy options includethe Group o Twenty (G0), the FinancialStability Board, the Basel Committee onBanking Supervision, and the Committeeon the Global Financial System. What causes asset bubbles to orm? Ina seminal piece (originally published in00), José Scheinkman and Wei Xiongobserve that asset bubbles are character-ized by high trading volume and highprice volatility. They develop a behavioralmodel o asset bubbles, assuming short-sale constraints. An asset buyer is willingto pay a price above undamentals be-cause, in addition to the asset, the buyerobtains an option to sell the asset toother traders who have more optimisticbelies about its uture value. WernerDe Bondt reviews Scheinkman andXiong’s paper and oers a detailed over- view o asset bubbles rom the perspectiveo a behavioral nancial economist—one who studies the eects o social, cogni-tive, and emotional actors on nancialdecisions. He challenges the idea that pure undamentals and rationality drivenancial decision-making and pricing.He argues the need to more ully incor-porate behavioral aspects (like investorovercondence) into investor decision-making models.To evaluate the role o monetary policy on the development o asset bubbles,Lawrence Christiano, Cosmin Ilut,Roberto Motto, and Massimo Rostagnoconstruct models to simulate 8 U.S. stockmarket booms. They show that i infationis low during stock market bubbles, acentral bank interest rate rule that nar-rowly targets infation actually destabilizesasset markets and the macroeconomy.The authors note that every stock market bubble o the past 00 years, exceptingbubbles in war years, occurred during yearso low infation. Early in an economicboom, the natural rate o interest is otenquite high. Most interest rate rules, how-ever, do not include a time-varying naturalrate o interest. Accordingly, i the naturalrate is high and infation is low, the cen-tral bank may set its target interest ratetoo low, and the bubble is urther ueled.Thus, the authors argue that a centralbank that ollows a “hands-o” approachto asset bubbles may actually encouragea bubble in its growing phase. To reducethis problem, the authors propose in-cluding credit growth (as a proxy or thenatural rate o interest) in the interest rate targeting rule to reduce volatility in asset prices and the real economy. Viral Acharya and Hassan Naqvi examinehow the banking sector may contributeto the ormation o asset bubbles whenthere is access to abundant liquidity. Ex-cess liquidity encourages lenders to beoveraggressive and to underprice risk inhopes that proceeds rom loan growth willmore than oset any later losses stemmingrom the aggressive behavior. Thus, asset bubbles are more likely to be ormed asa result o the excess liquidity. They con-clude that policy should be implementedto “lean against” liquidity growth. John Geanakoplos identies leverage asa major cause o asset bubbles. He citesour reasons why the most recent leveragecycle in the U.S. was worse than pre-ceding cycles. First, mortgage leveragereached levels never seen beore. Second,there was an additional leverage eect because o the securitization o mortgages.These two actors reinorced one another.Third, credit deault swaps (CDSs), whichdid not exist in previous cycles, playeda major role in the recent crisis. CDSshelped those optimistic about the housingmarket to increase their leverage at theend o the boom. But perhaps more im-portantly, they provided an easier meansor housing-market pessimists to leverage,
and made the crash come much earlierthan it would have otherwise. Finally,because leverage became so high andprices dropped so ar, a much larger num-ber o households and businesses endedup underwater than in earlier cycles.Evidence suggests that some bubbles canhave a signicant adverse impact on themacroeconomy when they burst. Is thereevidence that asset bubbles may haveadditional adverse eects? Robert Chirinko and Huntley Schaller empha-size the distortive impact o asset bubbles,regardless o whether they burst, on aggre-gate investment. A undamental unctiono the stock market is the ecient allo-cation o capital to its most productiveuses. Chirinko and Schaller nd empiricalevidence supporting the conjecturethat stock market overvaluation—i.e., abubble—can lead to overinvestment inthe bubble sector.
Public policy options
Given that bubbles may adversely aect the macroeconomy, what, i any, is theappropriate public policy response? Forat least the past 5 years, the FederalReserve has tended to ollow an approachto asset bubble management in whichthere is little or no restrictive monetary policy action during the bubble’s orma-tion and growth, but there is a prompt easing in the orm o quick reductions inmarket interest rates once the bubblebursts. (This monetary policy easing isaimed at reducing the potential loss o output and employment.) That is, there was little response to changes in asset prices, except insoar as they were seen tosignal changes in expected infation andeconomic slack. The intellectual ounda-tion or this approach was the seminalpiece by Ben Bernanke and Mark Gertler(originally published in 999). Their pa-per incorporates exogenous bubbles intoasset prices and constructs a nancialaccelerator model. Asset bubbles aect real economic activity via both the wealtheect on consumer spending and thenancial decisions o rms resulting romchanges in the value o assets on theirbalance sheets. Simulations o their modelled the authors to conclude that centralbanks should view price stability and nan-cial stability as highly complementary.This policy strategy became known asthe “Jackson Hole Consensus.”
Besides the reasons given by Bernankeand Gertler, there are other reasons orthe neutrality o the Fed while bubblesgrow: ) It is dicult to identiy a bub-ble and predict its ultimate magnitude;) the buildup o a bubble may takeseveral years and the Fed cannot ollow a restrictive monetary policy or such along and uncertain period; ) the ederalunds rate adjustments are a rather blunt instrument, which cannot be directedprecisely toward the bubble sector; and4) there is no need to directly target thebubble because i it increased wealth that stimulated consumption and resulted ininfation, then the Fed would act becauseo its price targeting policy.The Jackson Hole Consensus appearedto work well until September 008, whenthe nancial system came close to a com-plete meltdown. Kenneth Kuttner oersa detailed assessment o the Bernankeand Gertler results in light o the nancialcrisis.
He raises two points that challengethe policy implications o the Bernankeand Gertler results. First, macroeconomicstability and goods and services pricestability, in particular, do not guaranteenancial stability. Second, because thebursting o an asset bubble can severely damage the macroeconomy, the centralbank’s nancial stability mandate shouldnot be overlooked.So given the signicant adverse conse-quences o the recent nancial crisis,there has been a reconsideration o  whether central banks should addressasset bubbles. But even i a decision ismade to address bubbles, it is not ob- vious that monetary policy is the most appropriate policy tool. Monetary policy tools are rather blunt instruments, whichare intended to aect the overall levelo economic activity. A more targetedtool, directed at the bubble sector, might be preerred. In a seminal article (rst published in 00), Claudio Borio rec-ommends the use o macroprudentialtools to protect against nancial insta-bility (resulting rom bubbles bursting orother sources). He argues that it is im-portant to move beyond micropruden-tial regulation—which concentrates onindividual rms—and to account orcross-rm interconnections and any adverse externalities created when nan-cial institutions encounter problems.Such macroprudential tools includecountercyclical capital requirements,credit constraints, credit-to-gross-domestic-product (credit-to-GDP) ratiomonitoring, and margin requirements.
Directions for research
Benjamin Friedman observes that therecent crisis clearly challenges both theassumption o rationality employed inmuch o the previous analysis and theeciency o the nancial system to opti-mally allocate capital. He calls or addi-tional research to evaluate the allocativeeciency o the nancial sector andestimate what misallocations may becosting society. William Poole stresses that research on asset bubbles has essentially ignored much o the results rom controltheory rom the 960s and the rationalexpectations literature rom the 970s.Based on those two bodies o research,he argues that it may be a mistake to havepolicymakers attempt to manage what are suspected to be developing bubbles. Additionally, Poole argues that the build-up o the bubble may be less o a concern
Charles L. Evans,
Daniel G. Sullivan,
 Executive Vice President and Director o Research 
Spencer Krane,
Senior Vice President and Economic Advisor 
David Marshall,
Senior Vice President 
fnancial markets group 
Daniel Aaronson,
Vice President 
 microeconomic policy research 
 Jonas D. M. Fisher,
 Vice President 
macroeconomic policy research 
Vice President 
markets team 
 Anna L.Paulson,
Vice President 
fnance team 
 William A. Testa,
Vice President 
regional programs 
and Economics Editor 
Helen O’D. Koshy and Han Y. Choi,
Rita Molloy and Julia Baker,
Production Editors 
Sheila A. Mangler,
Editorial Assistant.Chicago Fed Letter 
is published by the EconomicResearch Department o the Federal Reserve Banko Chicago. The views expressed are the authors’and do not necessarily refect the views o theFederal Reserve Bank o Chicago or the FederalReserve System.© 0 Federal Reserve Bank o Chicago
Chicago Fed Letter 
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articles. To request permission, please contact Helen Koshy, senior editor, at --580 oremail Helen.Koshy@chi.rb.org.
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and other Bank publications are availableat www.chicagoed.org.
ISSN 0895-064

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