Can the Fed prevent financial asset bubbles?

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Co-written by Alex Verkhivker. Previously, Alex worked as an economic researcher with the Federal Trade Commission in Washington, DC and as an associate economist with the Federal Reserve Bank of Chicago.. He is also a graduate of the University of Chicago and UCLA.

Everyone agrees that a financial bubble is a time when prices exceed fundamental valuation. There was the South Sea Bubble, the Roaring Twenties, the Internet Bubble and our very last credit bubble. A year ago, in April, Princeton economist José Scheinkman illustrated three stylized facts about these bubbles at the Arrow Annual Conference at Columbia University. First, a bubble usually coincides with increases in the volume of ongoing transactions in the stock market. Second, a period of asset price deflation correlates with increases in the supply of the asset. Professor Scheinkman’s final observation is that such bubbles often occur in times of financial and technological innovation.

Can we predict financial asset bubbles?

The natural question for policymakers is whether asset price bubbles can be predicted. Three Nobel Prizes were awarded in 2013 to a trio of economists who built knowledge and discovered gaps in the way the general public understands how assets are valued and whether we can ever truly predict the next big financial bubble. A big determinant of the price of an asset is our general level of risk as consumers in the market, according to the three winners: Robert Shiller, Eugene Fama and Lars Hansen. According to this reasoning, factors that impact the general level of risk before making any investments may include the uncertainty of the actions Federal Reserve policymakers will take or the uncertainty of the political actions our Congress will take. If market participants are unsure whether tax hikes will take place or whether a debt ceiling debate will resolve, it is likely that the market will be more volatile than its natural equilibrium state and all of this is over. does not bode well for accurately assessing the value of an asset.

It is fair to say that even during the period defined by the “Great Moderation” from 1984 to 2006, America experienced the infamous stock market crash of October 1987 and the bursting of the dot-com bubble in 2000. Many will remember of the period of the Great Moderation as a time to congratulate yourself if you were an academic or industrial economist. The general drop in volatility has been good. Real GDP growth, industrial production indices and the unemployment rate have all stabilized. Even the crashes of 1987 and 2000 resulted in only short, mild recessions. The global financial crisis of 2008 marked a unique moment for the field of finance. This crisis has had a significant negative impact on US and global market economies.

The historical dangers of maintaining too loose monetary policy for too long

Historically, the stock and real estate markets have been the most important in terms of economic costs to investors and agents of the global economy when these types of bubbles first form and then eventually burst. The data gleaned from the textbooks of economic historians are of particular concern today for retail and institutional investors. Almost all of the stock market bubbles of the past 200 years, despite the bubbles of the war years, have occurred during periods of low inflation. Given the low inflation environment we find ourselves in right now, history suggests that if the Federal Reserve continues to keep interest rates near the lower limit of zero, it could potentially fuel another bubble.

An often overlooked prospect of the formation of asset bubbles is overconfidence among investors. In particular, research in behavioral finance – the subfield of finance that studies the effects of social, cognitive, and emotional factors on financial behavior – finds that periods of excess market liquidity could in fact be a nuisance. . In times of excess liquidity, lenders are overly aggressive and often underestimate the risk inherent in a financial transaction. Because investors hope that the funds from loan growth will offset their aggressive risk-taking, they are much more inclined to take positions in financial assets and instruments that they would otherwise leave in less liquid markets.

“Irrational exuberance” and the role of monetary policy

Over-optimism, or what Alan Greenspan called “irrational exuberance,” is a feared tenet in the world of asset management and retail investing. When times are good, our internal optimism for the good times continues to prevail. As a result, most investors do not effectively allocate their investments to their most productive uses, resulting in some assets valuing above their fundamental value. In their influential paper from 1999, Former Federal Reserve Chairman Ben Bernanke and New York University Professor Mark Gertler have shown how asset bubbles affect economic activity through a wealth effect. As a result of rising valuations, consumers are spending more and companies have over-leveraged positions on their balance sheets.

Given the importance of investor psychology in predicting bubbles, it’s important to remember that understanding brain circuitry remains a mystery, even as neuroscientists continue to study it. It goes without saying that asset bubbles will continue to form in new ways and eventually burst business cycle style, as Fed Vice Chairman Stanley Fisher pointed out last year. The fundamental question is to what extent decision-makers can predict them.

Ultimately, Mr. Bernanke and Mr. Gertler argue that it is difficult not only to identify bubbles, but also to predict their size, and therefore the Fed should not be concerned with identifying and preventing bubbles. asset bubbles.

However, new research in behavioral economics and behavioral finance demonstrates the importance of maintaining price stability to protect investors from our own psychological and heuristic biases. New evidence from the IMF and other sources shows that other ‘macroprudential’ policy tools in addition to monetary policy, such as countercyclical capital and leverage requirements, can be effective in guarding against asset bubbles . We hope that policymakers take into account the ability of economic policy not only to correct bubbles, but also to create them.


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