Tuesday, July 07, 2009

How do you detect and prevent asset bubbles?

The Greenspan Doctrine was that it is essentially impossible to detect or prevent or address asset bubbles in advance or in real-time and that the correct policy is simply to be prepared to clean up after them after they clearly have burst. That was the approach taken with the dot-com stock market bubble and that seemed to work out okay. But, it was also the approach taken with the recent housing, credit, debt securitization, executive compensation (not an asset per se, but still a bubble that caused problems), and commodities bubbles and people are not at all happy with the mess and "clean-up" process that has resulted in the current financial and economic crisis. Even Greenspan admits that maybe he made a mistake. There is a semi-widespread belief that we should and can identify and deal with asset bubbles before they create they create the kind of mess we are currently in.

In fact, in a recent speech, the president of the Federal Reserve Bank of New York, WIlliam Dudley, said that:

In my opinion, this crisis should lead to a critical reevaluation of the view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst.

As I wrote in 2006, this orthodoxy can be summarized by three propositions:

  1. Asset bubbles are hard to identify.
  2. Monetary policy is not well-suited to respond to bubbles.
  3. Thus, the cost/benefit tradeoff of "leaning against the wind" against asset bubbles is unfavorable.

From these propositions, the two important policy implications directly follow:

  1. The central bank should only take asset bubbles into consideration in the conduct of monetary policy to the extent that these asset bubbles affect the growth/inflation outlook.
  2. The monetary authorities should be there to "clean-up" after bubbles burst, both to prevent systemic problems and undesired downward pressure on economic activity and/or inflation.

Relative to this, I would argue that:

  1. Asset bubbles may not be that hard to identify--especially large ones. For example, the housing bubble in the United States had been identified by many by 2005, and the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007.
  2. If one means by monetary policy the instrument of short-term interest rates, then I agree that monetary policy is not well-suited to deal with asset bubbles. But this suggests that it might be better for central bankers to examine the efficacy of other instruments in their toolbox, rather than simply ignoring the development of asset bubbles.
  3. If existing tools are judged inadequate, then central banks should work on developing additional policy instruments. 

Let's take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep "skin in the game", I think the housing bubble might not have been so big.

I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier.

Harkening back to my earlier themes, I think we can respond in a number of ways:

  • First, we can do a better job understanding interconnectedness. This means changing how we oversee and supervise financial intermediaries.
  • Second, we can change the system so that it is more self-dampening.
  • Third, we can improve incentives.
  • Fourth, we can increase transparency.
  • Fifth, we can develop additional policy instruments. For example, we might give a systemic risk regulator the authority to establish overall leverage limits or collateral and collateral haircut requirements across the system. This would give the financial authorities the ability to limit leverage and more directly influence risk premia and this might prove useful in limiting the size of future asset bubbles.

I can't argue against any of that per se, but it still doesn't quite sound as if he is really hitting the sweet spot.

I do in fact believe that we can probably develop an approach to prevent many, but not necessarily all asset bubbles.

Whether we can successfully implement and execute an asset bubble detection and prevention scheme is unclear to me.

I would not note two key issues:

  1. We might well end up focusing far too much attention, energy, and resources on preventing the kinds of asset bubbles that can be reasonably dealt with with the Greenspan-ish "clean-up" doctrine. Too many false positives. We could end up severely stifling our economy and innovation, with no great benefit.
  2. We still will not be able to detect or prevent a significant number of the kind of systemic asset bubbles that ultimately lead to the kind of crisis we are currently in. Potential for false negatives.

Rather than misguideedly directing so much energy at "asset bubbles" per se, we should study and understand the impact of asset bubbles and seek to put in place circuit breakers that would effectively prevent asset bubbles and other forms of systemic risk factors from building up the kinds of systemic pressures that lead to systemic risks. This would tend to limit the formation of asset bubbles.

I think if we can focus on these kinds of issues, the net result will be to circumvent a lot of risky asset bubbles without needing to focus on the asset bubbles themselves.

One of the circuit breakers needs to be the identification and regulation of unregulated financial risk. Hedge funds, off-balance sheet operations, and the so-called shadow banking system were key factors in recent asset bubbles. They were clearly and widely known, so there was not a detection problem per se. Rather, there was no regulator in place who was authorized (or thought they were authorized) to stand up, step in, and institute control over activities which had the potential to cause systemic risk.

That is just one example of what I am talking about.

Whether this kind of thinking can be extended into a full-scale, robust, and reliable mechanism for circumventing asset bubbles remains to be seen.

In any case, my personal conclusion is that we do not yet as of today have even a draft proposal for the kind of asset bubble detection and prevention mechanism which would have prevented the current crisis. Sure, there are lots of good ideas being tossed around, but no detailed blueprint for a robust mechanism.

I suppose I should note that the gold bugs probably do feel that the gold standard or some other commodity-based money system would do the trick. Maybe no asset bubbles, but maybe because most people would not have any assets.

-- Jack Krupansky


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