Should central bankers actively undertake to burst asset bubbles, or should they stand around and watch them run out of steam, then try to clean up the mess by cutting interest rates? This has been the subject of a recent round of debate between central bank economists and other interest macro thinkers:
- Greenspan Fans at Jackson Hole May Differ on View of Bubbles
- Danger time for America: The economy that Alan Greenspan is about to hand over is in a much less healthy state than is popularly assumed
- Analysis: Burst bubbles - pyramid schemes
- Remarks by President Geithner: Some Perspectives on U.S. Monetary Policy
The problem with the entire discussion is that it assumes that asset bubbles “just happen”, or they are a result of some pathologies of investor behavior. The discussion takes bubbles as an exogenous event, basically a pathology of irrational market pricing.
One side of the debate believes that central banker has the ability to correct pathologies of market pricing, while the other side expresses skepticism about whether asset bubbles can event be identified. After all, if markets are efficient, then perhaps stocks, or homes, really are worth several multiples of what they cost a few years before.
The discussion ignores the pivotal role of central banks in creating asset bubbles. They do this by fixing interest rates at a level below the market rate -- the rate at which saving and investment would be equal -- and holding the rate there.
If interest rates were set by the market, an increased demand for investable funds would eventually have to result in a rise in interest rates because people only have so much present income out of which to save. The greater the demand for investable funds, the more people would have to be offered to part with increasingly scarce savings. The rise in interest rates would eventually limit the amount of funds that could be used to drive up asset prices.
During the stock bubble of the 90s, one often heard that stocks were cheap in relation to bonds because bond yields were low. The so-called “Fed Model” considers stocks to be cheap if the earnings yield on stocks is less than the yield on 10-year treasury bonds. During the last five years of real estate bubble, many analysts have said that homes were not overpriced “given the level of interest rates”. Any good that has a long time component in its valuation, whether investment (stocks) or consumption (homes) can be made to look cheap at a sufficiently low level of interest rates.
