Financial bubbles and macro prudential policy

In the field of monetary policy, there is one question that must necessarily be addressed: what should a central bank do in light of a financial bubble? Should it try to burst the bubble as soon as it arises or engage in damage control after a financial crisis occurs?

Personally, I don’t think that there is any one answer to this question- it would depend on too many variables. But there’s one solution that central bankers might consider: not creating bubbles in the first place. After all, bubbles don’t fall from the sky: for financial bubbles to occur, monetary policy must deviate from monetary equilibrium

For whatever reason, however,  mainstream analyses aren’t discussing the sources of financial bubbles. It is taken for granted that financial bubbles occur unpredictably as a result of irrational behavior and so central banks are simply tasked with either bursting bubbles or taking on the costs of a financial crisis.

A financial bubble occurs when the price of assets are with respect to what the fundamentals would justify. For instance, if the price of a stock of a company is justifiable by how well the company is doing and expected to do, then there is no bubble. But if the price is higher than the company’s value based on its actual performance and outlook, then there is a bubble. Because the price of stocks is expected to grow in the mid and long terms in a healthy and growing economy, rising prices of financial assets do not suggest that there is monetary disequilibrium.

The problem is that expectations of higher financial stock prices are not enough to explain a bubble. If I suspect that stock prices are constantly rising, then I can buy a stock and sell it afterwards. To do this, however, I need the resources to buy the stocks in the first place. The extra money used to buy financial assets need to come from either 1) consumption or 2) savings. The price of goods should fall or interest rates should rise; both effects counteract the incentive to buy financial stocks.

It would be a different story if the required monetary resources were to come from newly printed money. Miscalculated expectations would still need to be financed through a monetary policy deviation on behalf of the central bank. Instead of focusing on price levels, unemployment and output, central banks should instead focus on monetary equilibrium, allowing other variables to work their way to their own equilibriums. After all, a central bank is a key participant in the money market. As an institution that affects the supply of money, it’s ideal goal should be to keep an equilibrium between the money supply and money demand. This is the central idea behind the so-called “Hayek’s rule” or NGDP targeting.

Having the right target really is the best macroprudential policy.

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