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Monday, November 09, 2009

"Not All Bubbles Present a Risk to the Economy"

Frederic Mishkin says there's no reason to worry that a new bubble is inflating:

Not all bubbles present a risk to the economy, by Frederic Mishkin, Commentary, Financial Times: There is increasing concern that we may be experiencing another round of asset-price bubbles that could pose great danger to the economy. Does this danger provide a case for the US Federal Reserve to exit from its zero-interest-rate policy sooner rather than later, as many commentators have suggested? The answer is no. ...
Asset-price bubbles can be separated into two categories. The first and dangerous category is ... “a credit boom bubble”, in which exuberant expectations about economic prospects or structural changes in financial markets lead to a credit boom. The resulting increased demand for some assets raises their price and, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more, creating a positive feedback loop. This feedback loop involves increasing leverage, further easing of credit standards, then even higher leverage, and the cycle continues.
Eventually, the bubble bursts and asset prices collapse, leading to a reversal of the feedback loop. ... Indeed, this is what the recent crisis has been all about.
The second category of bubble, what I call the “pure irrational exuberance bubble”, is far less dangerous because it does not involve the cycle of leveraging against higher asset values. Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values... This is one of the key reasons that the bursting of the bubble was followed by a relatively mild recession. ...
Because the second category of bubble does not present the same dangers ... as a credit boom bubble, the case for tightening monetary policy to restrain a pure irrational exuberance bubble is much weaker. ... Nonetheless, if a bubble poses a sufficient danger to the economy as credit boom bubbles do, there might be a case for monetary policy to step in. ...
But if bubbles are a possibility now, does it look like they are of the dangerous, credit boom variety? At least in the US and Europe, the answer is clearly no. Our problem is not a credit boom, but that the deleveraging process has not fully ended. Credit markets are still tight and are presenting a serious drag on the economy.

Tightening monetary policy in the US or Europe to restrain a possible bubble makes no sense... At this critical juncture, the Fed must not take its eye off the ball by focusing on possible asset-price bubbles that are not of the dangerous, credit boom variety.

I've mostly heard the worries expressed in terms of inflation. I think the risks are asymmetric. Raising rates too soon and sending the economy tumbling back into a recession is much more costly than an outbreak of inflation that persists until the Fed can bring it back under control.

    Posted by on Monday, November 9, 2009 at 05:40 PM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (14)


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