Central banks should prick asset bubbles

Central banks should prick asset bubbles

By Paul De GrauwePublished: November 1 2007 17:58 | Last updated: November 1 2007 17:58

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.
There is a second reason that the hands-off approach has been
shown to be wanting. During the past few years, a significant part of
liquidity and credit creation has occurred outside the banking system.
Hedge funds and special conduits have been borrowing short and lending
long and, as a result, have created credit and liquidity on a massive
scale. As long as this liquidity creation was not affecting banks, it
was not a source of concern for the central bank. However, banks were
heavily implicated. Thus, the central bank was implicitly extending its
liquidity insurance to institutions outside the regulatory framework.
It is unreasonable for a central bank to insure activities of agents
over which it has no super­vision, just as it would be unreasonable for
an insurance company selling fire insurance not to check whether the
insured persons take sufficient precautions against the outbreak of
fire.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. It has been argued that even if central
banks can detect bubbles, they are pretty much powerless to stop them.
This argument is unconvincing. It is not inherently more difficult to
stop asset bubbles than it is to stop in­flation. Central banks have
been highly successful at stopping inflation. 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. The writer is professor of economics at the University of Leuven