Asset Price Instability and Policy Responses: The Legacy of Liberalization

Article excerpt

The problem of asset price bubbles, and more generally of instability in the financial system, has been a matter of concern since the 1980s but has only recently moved to the center of the macroeconomic policy debate. Among the events contributing to concern about asset prices, the most notable have been the boom and bust in share prices, particularly those of technology stocks such as "dotcoms," and the subsequent boom in property prices. These asset price movements have been experienced, to varying degrees, in most OECD economies, including the United States, the United Kingdom, and (in the case of housing) Australia. Earlier episodes of boom and bust have affected East Asia, the Nordic countries, Mexico, Russia, parts of Latin America, and, most notably, Japan.

The main concern with bubbles arises when they burst, imposing losses on investors holding the bubble assets and potentially on the financial institutions that have extended credit to them. Financial stress might be limited to the failure of individual financial institutions that become overextended during the boom. Increasingly, however, the kinds of financial distress being encountered are systemic, with many institutions operating in a similar mode and simultaneously miscalculating and confronting difficulties. This implies trouble for a wide range of institutions with the strong potential for flow-on effects in the real economy, perhaps leading to a recession or debt deflation. There is no room in this paper to delve into the history of such crashes other than to note that the costs of dealing with banking crises through bailouts and recapitalization during the 1990s ranged from 5 percent to 40 percent of GDP, with even larger effects in terms of lost output (Macfarlane 1999, table 1).

As the frequency and severity of asset price fluctuations, including putative bubbles, has increased, there has been a corresponding increase in interest in measures that may prevent the emergence of bubbles or to seek gradual deflation of bubbles rather than catastrophic busts. Most attention has focused on the idea of making asset price stability a target of monetary policy, either in its own right or as a signal of incipient consumer price inflation. To deal with asset inflation Claudio Borio and Philip Lowe (2003) have called for a "subtle shift" in a policy paradigm based on inflation targeting. There has also been some consideration of a possible role for prudential policy (Schwartz 2002).

Subtle as these policy shifts may appear, they nevertheless involve a fundamental change in thinking about the role of financial markets. In the deregulated system, the task of allocating investment capital and consumer credit between individuals, firms, and nations is left to financial markets. As Jeffrey Carmichael and Neil Esho (2001) have observed, intervention aimed at changing asset prices and other financial market outcomes, such as "excessive" credit growth, are logically inconsistent with the "deregulated" framework of monetary policy and financial regulation that emerged in the wake of breakdown of the Bretton Woods system in the 1970s. This framework was based on the efficient markets hypothesis.

As Borio and Lowe (2003, 113) have observed, framing the debate in this way "can easily see it stray into almost ideological territory, unnecessarily pitching supporters and skeptics of 'market efficiency' against each other." Borio and Lowe regard this division as a source of artificial difficulties. In this paper, we argue on the contrary that the role of the efficient markets hypothesis is crucial and cannot be disregarded. It follows that the debate must have an ideological, as well as a technical, character. Any serious attempt to stabilize financial market outcomes must involve at least a partial reversal of deregulation.

This paper is organized as follows. We begin with a brief survey of the empirical literature on asset price bubbles and asset price volatility, with particular emphasis on the period following financial deregulation. …