New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy

New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy

New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy

New Perspectives on Asset Price Bubbles: Theory, Evidence and Policy

Synopsis

This volume critically re-examines the profession's understanding of asset bubbles in light of the global financial crisis of 2007-09. It is well known that bubbles have occurred in the past, with the October 1929 crash as the most demonstrative example. However, the remarkably well-behaved performance of the US economy from 1945 to 2006, and, in particular during the Great Moderation period of 1984 to 2006, assured the economics profession and monetary policymakers that asset bubbles could be effectively managed with little or no real economic impact. The recent financial crisis has now triggered a debate about the emergence of a sequence of repeated bubbles in the Nasdaq market, housing market, credit market and commodity markets. The Greenspan-Bernanke Federal Reserve has followed an asymmetric approach to bubble management. This method advocates no monetary policy action during the bubble formation and growth, but a speedy response with a reduction in market rates when a bubble bursts to reduce the potential loss of output and employment. It was supported by academic research and seemed to work well until September 2008 when the financial system came close to a complete collapse.

The realities of the recent financial crisis have intensified theoretical modeling, empirical methodologies, and debate on policy issues surrounding asset price bubbles and their potentially considerable adverse economic impact if poorly managed. Choosing to take a novel approach, the editors of this book have selected five classic papers that represent accepted thinking about asset bubbles prior to the financial crisis. They also include original papers challenging orthodox thinking and presenting new insights. A summary essay by the editors highlights the lessons learned and experiences gained since the crisis.

Excerpt

Douglas D. Evanoff, George G. Kaufman, and A. G. Malliaris

The primary purpose of this book is to critically reexamine the profession’s understanding of asset price bubbles in light of the major financial crisis of 2007–2009. It is well known that asset bubbles have occurred in the past, with the October 1929 stock market crash as perhaps the most demonstrative example. However, the remarkable positive performance of the U.S. economy from 1945 to 2006, and, in particular, during the Great Moderation of 1984 to 2006, suggested to the economics profession and monetary policymakers that asset bubbles could be effectively ignored with little real adverse economic impact. For example, the October 1987 one-day U.S. stock market crash of 20% did not seriously impact the real economy. Likewise, the bursting of the Internet bubble in 2000, when the NASDAQ dropped by 70% from its level of about 4,500 in early 2000 to 1,500 in April 2002, contributed only to an eight-month mild recession from March to November, 2001.

In contrast to these mild real economic consequences of asset bubbles bursting, both the Great Crash of 1929, which was followed by a severe economic depression, and the crash of the Japanese stock and real estate markets that led to the so-called “lost decade” in Japan should have reminded us that the severity of the spillover from asset bubbles bursting should not be underestimated.

The recent financial crisis of 2007–2009, which was followed by the “Great Recession” lasting 18 months from December 2007 to June 2009, has triggered a debate about what we really know about asset price bubbles and how (and whether) they can be managed in the public interest.

There are various components to this debate. For example, the efficient markets hypothesis views extraordinary movements in asset prices as a consequence of significant changes in information about fundamentals. This approach to asset pricing downplays the need to consider asset bubbles as a source of financial instability. It is . . .

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