Asset Price Bounds and Bubbles

A call to prick bubbles before they get dangerous by setting bounds for asset prices, and taking corrective action when prices move outside of the designated range:

Put the puritans in charge of the punchbowl, by Arvind Subramanian and John Williamson, Commentary, Financial Times: The ... idea of Alan Greenspan ... that monetary and regulatory policy cannot prick asset price bubbles but should deal with the consequences when the bubble has burst – now looks dangerously quaint. ...

The intellectual justification... – articulated by Ben Bernanke... – was that identifying equilibrium levels of asset prices is difficult; and policy tools to prick or limit bubbles are limited. The unmentioned but perhaps real rationale is a kind of implicit market fundamentalism: markets value assets best, and even if markets make mistakes, policymakers can never be sure in advance whether and to what extent mistakes have been made.

However, the wreck that is today’s financial system is testimony to the catastrophically flawed nature of that doctrine. Policymakers have no choice but to have a view on what constitutes a reasonable or equilibrium level of all asset prices. Of course, determining such levels is subject to uncertainty. The most it is prudent to contemplate is that policymakers should determine not reasonable levels but reasonable zones for asset prices. ...

The width of the zone should certainly vary depending on the asset and the associated uncertainty in determining equilibrium asset price levels. Note that history provides guides for assets other than exchange rates: when house price/income ratios, or price/earnings ratios depart far from historical levels, they revert. One might accordingly think of a zone for house prices of, perhaps, plus or minus 30 per cent; and for equities of, say, plus or minus 40 per cent; and, more controversially, for oil of, say, $40-$80 per barrel. ... Even zones this wide would have called for action – on exchange rates, house prices, equities and oil prices. ...

The guidance zones should be made public. They would provide a signal that departures from these zones would elicit policy action. These actions should become stronger the greater the departures...

Policymakers must combine paranoia and puritanism: paranoia about sharp departures of asset prices from reasonable levels and puritanism in taking away the punchbowl (by tightening prudential and monetary policies) to prevent the bubble from becoming intoxicating. ... Mr Greenspan wanted to address the hangover. It is surely better to avoid drunkenness.