Can We Prevent Asset Bubbles? 16 comments
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Caroline Baum says it's time to reconsider the resistance to preemption - using monetary policy to pop bubbles before they get too big.
From "Central Banks Reconsider Doctrine of Preemption", Bloomberg:
It is an article of faith that central banks can't identify an asset bubble ex ante; that they don't have better knowledge of the appropriate level of asset prices than financial markets; that they can best serve the public by addressing the aftereffects of the bubble once it bursts.
With central banks around the world pulling out all the stops to keep money flowing, banking systems functioning and economies growing (or not sinking so much), perhaps a re- evaluation of the doctrine of preemption is in order. If central banks are willing to risk trillions of taxpayer dollars in their role as lender of last -- make that only -- resort, then an ounce of prevention may just be a better policy prescription. ...
''Prevention (of asset bubbles) is the best way to minimize costs for society from a longer-term perspective,'' said Otmar Issing, the former chief economist for the Deutsche Bundesbank and European Central Bank, in a Feb. 19, 2004, Wall Street Journal op-ed. ''Most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit.'' ...
The current crisis, which has witnessed the demise of venerable financial institutions and the intrusion of government into the private sector in ways not seen since the 1930s, is prompting many economists to reconsider the doctrine of preemption.
''I was always skeptical of the ability of the central bank to target asset prices,'' [former Richmond Fed President Al] Broaddus... ''I haven't given up that skepticism, but after an event of this magnitude, the Fed has an obligation to look at this.'' ...
Hindsight is easy. The goal is to find a framework so that policy makers can practice preventative, not curative, medicine.
In sticky price models, inflation is problematic, in part, because it distorts relative prices. Prices are reset with differing frequencies rather than continuously in these models, and as some prices are reset while other remain fixed, relative prices are distorted.
The goal of monetary policy is to eliminate these distortions as much as possible, that's the best way to stabilize output and employment, and pursuit of that goal generally results in a Taylor rule type policy prescription that links the federal funds rate to deviations of output and (some measure of) inflation from their target rates.
I'm starting to think of these relative price distortions, which generate departures from long-run fundamentals, as bubbles - froth perhaps for prices that are only moderately sluggish in responding to shocks. From this perspective, if you accept the idea that these distortions are bubbles (you may not), the Fed already tries to pop bubbles, just not asset bubbles.
And it does this in an automatic way. How? By creating a price index where the individual prices that make up the index are weighted according to their rigidity (throwing out volatile prices like food and energy, or trimming out a certain percentage of volatile prices, can be viewed as an attempt to approximate this theoretical weighting scheme). This index is then monitored closely, and when it goes up, the federal funds rate is raised in response and that has the effect of minimizing distortions. Thus, as prices begin to rise, because of a bubble or for other reasons, the Fed responds aggressively. In normal times, the federal funds rate is increased more than one-to-one with increases in inflation in an attempt to halt further price escalation.
[There is a similar argument regarding wage inflation based upon the same ideas - preventing distortions in labor markets - and the theoretical models indicate that an index of wage movements should also be part of the rate-setting decision. This is not done explicitly, but it is done implicitly since wage movements are an important factor in FOMC discussions.]
There is one set of prices, however, that theory says ought to be part of the rate-setting decision, but they are missing. And interestingly, and perhaps only coincidentally, the one set of prices that are not monitored and responded to just happen to be the place where bubbles erupt - asset prices.
But if we include these prices in the Fed's policy rule so that whenever asset prices rise the Fed responds by increasing the target interest rate, and if we weight the asset prices properly so that some prices, e.g. housing prices, receive more weight (house prices are notoriously sticky, so theory says they ought to receive a lot of weight), then perhaps it's much less likely that a little bubble turns into a big bubble. Asset price inflation will be stopped by increases in the federal funds rate (and if it isn't stopped by interest rate hikes, then other measures can be implemented).
With this approach, you don't have to debate whether a particular price run is a bubble or not, if it is creating asset price inflation, then there will be an automatic response of the federal funds rate to temper the increase. To me, not having to know if it is a bubble or not is an attractive feature.
If we didn't identify one of the largest bubbles in memory, and for the most part people didn't, I'm not confident we will be able to come to any kind of consensus about "ordinary" sized bubbles before it's too late.
And if that's the case, waiting until we are certain we are observing a bubble will delay policy beyond the point where it can be helpful. Instead of endlessly debating whether a particular price run is a bubble or not, and not having the argument settled until it pops and it's too late to do anything about it, with this approach policy responds immediately to eliminate distortions.
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This article has 16 comments:
The monetary authorities are charged with the task of pursuing aggregate price stabilitiy. Unless/until prices move uniformly within each and every asset class, you will have price differentials that must lead to one asset class becoming inflated relative to the rest of the basket.
To then alter monetary policy in an effort to combat the creation of some asset bubble, real or imagined, the monetary authorities will have abandoned their goal of aggregate price stability.
Asset bubbles are a normal part of financial life. Deal with it.
1) We could let the government decide what the price for everything should be. Uh, nah. Didn't work too well in the USSR or East Germany.
2) The central banks could stop adding to the money supply and provide a stable monetary framework where the market could function to set prices in order to allocate scarce resources based on actual demand.
While 2) would do the trick, it sort of makes the central bank pointless and renders the entire Keynesian monetary theory moot so it won't ever happen voluntarily.
Until the central banks of the world stop inflating the supply of money, there will continue to be 'asset bubbles' formed due to excess money chasing the hot asset class of the day.
The solution is to get rid of the central banks, return to a fixed gold standard, and eliminate fractional reserve banking, but that will never happen so asset bubbles are here to stay.
I salute your honesty; you are obviously smart enough to be bought off by the Fed but haven't been.
See ya in the Concentration Camp.
Of course communism can stop them but then everyone starves --see USSR. and China.
Greenspan may have made the bubble worse (although that is debateable) but he did not cause it---we all did.
Local bubbles can be caused by an increase of the money supply even if it is gold, true. This apparently happened with the Tulip Craze. But fractional reserves make it worse and government backed central banks cause catastrophe.
The solution, as is usually the case, is more freedom, not less.
Since most 'asset bubbles' are created by people looking for the 'get rich quick' option, and since the unnatural upward spiral in price is the product of a feeding frenzy of speculators buying and selling in the short term. (ie Day trading in stocks and commodities or property flipping in real-estate) The simplest solution would be to heavily tax 'short term capital gains' while reducing taxes on 'long term capital gains.
For example, if capital gains taxes on stocks, commodities or real-estate held by a person for any period less than one year had been set to a value of 60%. What percentage of the 'day traders' and 'real-estate speculators' who created our current mess would have never seen the profit in doing what they did?
The basic premise here is to use regulatory means to force the greedy to behave in a manner that supports the basic market function rather than exploiting it to the detriment of everyone else. This kind of pre-emptive action, while not a panacea, would moderate the deleterious influences of the 'market gamblers' enabling the market systems to work as they should.
I find it hard to believe just how fiscally naive you can be. Your supercilious sermon and conclusions assume that government agencies like the Fed, do their level best to adjust indicators and economic monitors purely based on the data and completely and rather stupidly in my opinion, ignore the fact that there are external forces at work, like politicians wanting to get re-elected for example, that result in these indicators being grossly distorted. I think it is pretty much accepted among serious data-response driven market participants that the vast majority of economic indicators generated by government agencies are manipulated past the point of usefulness in any real sense.
In other words, because these indicators (like GDP, CPI, PCE etc) grossly distort the true picture, relying on them to gauge the true picture is a fool's game. And any system based on these indicators to short-circuit the build up of bubbles will be virtually useless as a result.
Agreed... cutting the capital gains and dividend taxes to 15% greatly changed the risk-reward equation for day traders, derivitives traders, and real estate flippers.
While I don't agree with 60%, I think if we want financial stability and an economy based on actual production instead of speculation and debt, this rate will need to rise to equal the level of taxation on earnings.
Think about it. Taxes discourage the things being taxed (e.g. the effects of rising taxes on reducing cigarette consumption are well documented).
Why is our tax structure set up to tax productive work at up to 35% but speculation at 15%? What did we expect would happen? What is a wealthy person supposed to do with his/her money? Invest in a productive business and get taxed at 35% or ride investment trends and get taxed at 15%?
Note also that using taxes to limit speculation is much more straightforward, simpler, and less risky to the currency than the author's command-and-control suggestion. Plus, if a bubble occurred, government revenues would skyrocket as they did in the 90's. That, plus avoiding more trillion dollar bailouts, is the only way we can pay for the national debt and entitlements.
As far as all the gold standard talk is concerned, I suppose there were no bubbles nor bank runs prior to the 70's or 30's (whichever bestselling author theory you subscribe to).
The 60% was merely a hypothetical... my actual idea would be a phased percentage that encourages good investment habits...
1yr or less 50%
1yr - 5yr 35%
5yr - 10yr 20%
10yr - 20yr 10%
I would also suggest eliminating capital gains on investments held longer than 20 years as a reward to the investor for staying with their saving plan. Also, most folks who've been invested in a particular stock or property 20 years are nearing or into retirement and thus deserving of the break.
Changing fiscal policy to discourage "speculation" would also reduce market liquidity greatly, hence higher volatility. Why tax any income? It's consumption (sales tax) that should be looked at. This is an anathema when growth is the only mantra.
"Since most 'asset bubbles' are created by people looking for the 'get rich quick' option, and since the unnatural upward spiral in price is the product of a feeding frenzy of speculators buying and selling in the short term. (ie Day trading in stocks and commodities or property flipping in real-estate) "
Partially true. The greed aspect of inflating the bubble is usually present, but what enables it is an easy access to funding in one form or another so that anyone and everyone can participate. The easy funding can take different forms. Fractional reserve banking and margin limits are two of the more common avenues.
Simply blaming speculation is too narrow a brushstroke. The only way 'pure speculation' can run up a price is if there are a plentitude of eager buyers, each believing the asset is still undervalued.
This in itself is not a problem as true speculation is a zero sum game. One party wins what the other loses once the price goes back down. If the loser has enough of his own money to cover the loss then he is the only party that suffers from his mistake.
However, if the loser borrowed heavily to buy and then lost, he not only suffers the loss, but is now in debt as well. If he goes bankrupt then the lender suffers too.
This is what we are seeing today. Too many eager participants in the housing market 'playing' with borrowed money and putting themselves in a position where even a small move against them is enough to bury them forever and put a strain on the next domino in the chain.
Enough failed, one-sided positions in this manner will put so much strain on the next domino that it too will give way and topple into the next domino, ad nauseum.
Too many people making "all or nothing" bets with borrowed money, whether stocks, real estate, South Sea trading companies, tulips, or CDOs usually comes to a very bad end.
Speculation is the vehicle, excess leverage is the dynamite which destroys the vehicle.
The old adage "Don't risk more than you can afford to lose." has been ignored on a massive scale this time around. From low-rate interest only adjustable loans, to packaged MBS with leverage, to CDOs on those packages. Everyone along the line risked more than they could truly afford to lose.
Now we are all paying for it.
Concentration makes my brain hurt. All those cards to remember when you're trying to find a match.
Once I failed the "don't EVER use Austrian Economics" portion of the test for President I was disqualified for a lifetime at the FED. C'est la vie.
I have been reduced to annually doubling (or more) my account balance by speculation in order to survive. Sigh ... it's a hard life, but now that I have secured a really big interest only adjustable rate loan I'm ready to get started. I figure if I can make 0.01 per share for 100,000 shares a day I will be able to get by.
I'm generally not a fan of using taxation to manipulate behavior because for a variety of reasons (ignorance foremost) the unintended consequences of directed taxation usually generate far more harm than good. I've tended towards monetarist solutions--manipulatio... of monetary demand like is being done now by adjusting the Fed rate--that allow money markets to set the ultimate prices and thus control the growth or contraction of the money supply. Arguably if Greenspan had raised rates the Fed could have reduced or stopped the real estate bubble from forming. But in the early 1980s we saw that it takes rates upward of 20% to cool enthusiasm and rates that high cause major inflation problems, not to mention the damage done to "legitimate" borrowers who aren't borrowing to buy into the bubbling asset class.
Something else that really needs to happen is getting a grip on what "money" is and how it should be created. I have studied financial economics and I can assure you that nobody--NOBODY--actual... understands money. It's like consciousness: we all have it and use it but nobody knows what it is or the mechanics of how it works. In the 1920s CH Douglas came up with an alternate system of money called "social credit" that was widely denounced by the financial powers-that-be. Douglas has good insights into the question of what money is and how it should be used to best facilitate the production and consumption of real economic goods. Douglas sees money as "financial credit" whose only legitimate worth is in the ability of a country's economy to generate real wealth to spend the money on. The downside of Douglas' system is that it would require near-omniscient technocrats to run the financial system. Anyway, now that we're in the midst of a monetary shakeout, it might be a good time to start thinking about getting to understand what money is and how it works before we start building up for the next one. We need a good theory of money.
Read Below.. Very interesting.. Similar thing has happened in US and hope it shouldn't happen in Mumbai.
Here's a very intersting anecdote that describes how an "asset bubble"
builds up and what are its consequences.
Read it even if it confuses you a bit...things will be clear as you reach the end....
ANCEDOTE -
Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollar as there were only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.
2) B decided to purchase the land from A for 1 dollar. So, A and C now each own 1 dollar while B owned a piece of land that is worth 1 dollar.
The net asset of the country = 3 dollar.
3) C thought that since there is only one piece of land in the country and land is non produceable asset, its value must definitely go up. So, he borrowed 1 dollar from A and together with his own 1 dollar, he bought the land from B for 2 dollar.
A has a loan to C of 1 dollar, so his net asset is 1 dollar.
B sold his land and got 2 dollar, so his net asset is 2 dollar.
C owned the piece of land worth 2 dollar but with his 1 dollar debt to A, his net asset is 1 dollar.
The net asset of the country = 4 dollar.
4) A saw that the land he once owned has risen in value. He regretted selling it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollar from B and and acquired the land back from C for 3 dollar. The payment is by
2 dollar cash (which he borrowed) and cancellation of the 1 dollar loan to C.
As a result, A now owned a piece of land that is worth 3 dollar. But since he owed B 2 dollar, his net asset is 1 dollar.
B loaned 2 dollar to A. So his net asset is 2 dollar.
C now has the 2 coins. His net asset is also 2 dollar.
The net asset of the country = 5 dollar. A bubble is building up.
(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollar. The payment is by borrowing
2 dollar from C and cancellation of his 2 dollar loan to A.
As a result, A has got his debt cleared and he got the 2 coins.. His net asset is 2 dollar.
B owned a piece of land that is worth 4 dollar but since he has a debt of 2 dollar with C, his net Asset is 2 dollar.
C loaned 2 dollar to B, so his net asset is 2 dollar.
The net asset of the country = 6 dollar. Even though, the country has only one piece of land and 2 Dollar in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blowed. An evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollar in circulation, I think after all the land that B owns is worth at most 1 dollar only."
A also thought the same.
(8) Nobody wanted to buy land anymore. In the end, A owns the 2 dollar coins, his net asset is 2 dollar. B owed C 2 dollar and the land he owned which he thought worth 4 dollar is now 1 dollar. His net asset become -1 dollar.
C has a loan of 2 dollar to B. But it is a bad debt. Although his net asset is still 2 dollar, his Heart is palpitating.
The net asset of the country = 3 dollar again.
Who has stolen the 3 dollar from the country ?
Of course, before the bubble burst B thought his land worth 4 dollar.
Actually, right before the collapse, the net asset of the country was 6 dollar in paper. his net asset is still 2 dollar, his heart is palpitating.
The net asset of the country = 3 dollar again.
(9) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollar bad debt to B but in return he acquired the land which is worth 1 dollar now.
A owns the 2 coins, his net asset is 2 dollar. B is bankrupt, his net asset is 0 dollar. ( B lost everything ) C got no choice but end up with a land worth only 1 dollar (C lost one dollar) The net asset of the country = 3 dollar.
****************End of the story*****************... **
There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -
(1) When a bubble is building up, the debt of individual in a country to one another is also building up.
(2) This story of the island is a close system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
(3) An overdamped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the loser. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrain to take part in the game. At the end of the day, he will neither win nor lose. But he will see the value of his money or land go up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A ) and take part in the game.. But you must know when you should change everything back to cash.
(8) Instead of land, the above applies to stocks as well.
(9) The actual worth of land or stocks depend largely on psychology.
Do forward it to your friends wherever you can to spread the knowledge. You will surely be remembered for Good.
Regards,