Asset Bubbles and the Role of Central Banks

by: Markham Lee

Since the role, efficacy and responsibility of central banks is a popular topic in this age of credit market turmoil, the mortgage crisis, etc, here is an excellent article from last week’s Financial Times regarding the responsibilities of Central Banks with respect to asset bubbles. The overriding idea is that central banks should be more involved in the control and outright "pricking" of asset bubbles in addition to regulating the credit markets, lest they wreak havoc on the economy.

From the Financial Times:

The credit crisis that hit the world economy in August teaches us many lessons about the workings of integrated financial markets. It also teaches us something about the responsibilities of central banks.

Until the crisis, the consensus view was that central banks should target inflation and that is pretty much all they should do. In this view, central banks should not target (or try to influence) asset prices either, as was stressed by the former Federal Reserve chairman Alan Greenspan, because central banks cannot recognise bubbles ex ante. Or, if they can, the macro­economic consequences of bubbles and crashes are limited as long as central banks keep inflation on track. Inflation targeting, we were told, is the new best practice for central bankers that makes it unnecessary for them to try to influence asset prices.

The credit crisis has unveiled the fallacy of this hands-off view. If the banking system were insulated from the asset markets, the view that monetary policies should not be influenced by what happens in asset markets would make sense. Asset bubbles and crashes would affect only the non-banking sector and a central bank is not in the business of insuring private portfolios…

The problem that we have seen in the recent crisis is that the banking sectors were not insulated from movements in the asset markets. Banks were heavily implicated both in the development of the bubble in the housing markets and its subsequent crash. Since the banking system was implicated, the central banks were also heavily involved owing to the fact that they provide insurance to the banks as lender of last resort. Some may wish that central banks would abstain from supplying this insurance. However, central banks are forced to provide liquidity during a crisis because they are the only institutions capable of doing so. Thus, when asset prices experience a bubble it should be a matter of concern for the central bank because the bubble will be followed by a crash, and that is when the balance sheet of the central bank will be affected…

… So, what should central banks do besides target inflation? First, central banks should recognise that asset bubbles are a source of concern and that they should act on the emergence of such a bubble. The argument that a bubble can never be recognised ex ante is a very weak one. One had to be blind not to see the bubble in the US housing market, or the internet bubble. This is the case for most asset bubbles in history…

… Second, central banks should be involved in the supervision and regulation of all institutions that create credit and liquidity. The UK approach of dissociating monetary policy from banking supervision has not worked. Central banks are the only insurers against liquidity risks. Therefore they are the ones who should control those who ­create credit and liquidity. Failure to do so will continue to induce agents to create excessive amounts of liquidity, endangering the financial system.

The fashionable inflation-targeting view is a minimalist view of the responsibilities of a central bank. The central bank cannot avoid taking more responsibilities beyond inflation targeting. These include the prevention of bubbles and the supervision of all institutions that are in the business of creating credit and liquidity.

I suppose there are those who may feel that a central bank getting involved in regulating credit and controlling asset bubbles runs contrary to the idea of a free market, however, how is that different from the Fed injecting liquidity, cutting rates, et al, when things go bad? The markets can't have it both ways - e.g. the convenient intervention paradox: crying foul when a central bank (or other Governmental agency) intervenes to protect the economy during the good times, and begging those same agencies for a bailout when times are bad

The "convenient intervention paradox" is especially glaring when you consider that the un-desired type of intervention could very well prevent the pain which sends the financial sector running to central banks for help in the first place. The Fed could’ve easily intervened during the credit bubble and demanded tighter standards on mortgages, cut the supply of cheap money, etc, with the result being a more stable economy. I’m sure the banks would’ve cried foul and said it ran contrary to free markets, was destroying wealth, etc, but it would’ve been for the best.

My cynical view is that many in the financial sector knew that Fed intervention during the housing bubble, cheap money craze, etc, was sorely needed. However, during an asset bubble everyone thinks “it won’t happen to me” and hopes to make a ton of money and get out before it’s too late. Unfortunately, when everyone thinks like that you get the mess we have today.


The Financial Times: “Central banks should prick asset bubbles” –Paul De Grauwe, November 1, 2007