Academic journal article Chicago Fed Letter

Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies

Academic journal article Chicago Fed Letter

Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies

Article excerpt

A recent conference cosponsored by the World Bank and the Chicago Fed brought financial industry experts together to discuss the phenomenon of asset price bubbles, which many identify as a feature of the U.S. stock market in the late 1990s. Participants analyzed the difficulties in identifying asset bubbles and explored ways that central banks and other monetary authorities might help ease their effects.

Many view recent activity on Wall Street as representing the bursting of the "great stock bubble of the 1990s." However, how do we really know whether we have experienced or are experiencing a bubble? Since the definition of a bubble, generally a period in which securities trade at prices not justified by fundamentals such as earnings, is not precise in economics or finance, experts offer different answers to this question. Given the difficulties in determining the bubble's presence after the fact, the identification problem is even more difficult during the bubble's formation. However, this identification is very important. Among other things, the existence of such a bubble could require central banks and financial authorities to alter their monetary and banking policies. The World Bank Group and the Federal Reserve Bank of Chicago sponsored a conference, "Asset Price Bubbles: Implications for Monetary, Regulatory, and International Policies," held at the Chicago Fed on April 22-24, 2002, to address these issues. Leading academics, policymakers, and practitioners from throughout the world gathered to present current work on this subject. This Chicago Fed Letter summarizes the discussions and conclusions from this conference.' The keynote speaker on the opening night, Randall Kroszner, member of the President's Council of Economic Advisers, discussed the information difficulties inherent in the identification of bubbles. "The research record on asset price measurement is far from being sufficient to build a policymaker's confidence," said Kroszner. He pointed to various inconsistencies in financial history for periods in which the Standard & Poor's 500 rose rapidly. For example, the peak in 1956 was not followed by a precipitous decline, while those in 1929 and 1937 were. Even some purported bubble periods of the past are still in question, making real-time identification of bubbles even more difficult. One thing that financial authorities can do to better identify and prevent bubbles is to improve the public's access to accurate information. To make ajudgment about the appropriate price for a particular stock, an investor must have solid information about the firm's fundamentals. The access to this information must be public and widespread. "When a price seems to outstrip fundamentals, an investor logically asks whether it is a bubble or whether he or she does not have access to important information about fundamentals," said Kroszner. He supports recent efforts by the Bush administration to increase and improve this information, including the President's ten-point plan to improve financial disclosure and enhance shareholder protection and a proposal to reform 401 (k) retirement account rules to expand the availability of investment advice. The Governor of the Bank of France, Jean-Claude Trichet, opened the first morning of the conference with a central banker's perspective. Trichet offered a cautious stance on the decision of whether asset prices should be an input or target of monetary policy. While acknowledging the serious cause for concern that asset price developments can generate, he argued that the difficulties in determining the existence of a bubble could cause a policy targeting or including asset prices to do more harm than good. Determining the existence of a bubble requires knowledge of what the "true" asset prices should be. While this may be relatively easy to determine theoretically, it is impossible in practice. Also, if central banks took the position of always counteracting the deflation of a bubble, agents may see stock investment as relatively riskless, and equity markets would be exposed to moral hazard. …

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