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Sunday, June 1, 2008

Monetary Policy and Asset Bubbles

Gerald P. O'Driscoll Jr. has a new paper titled Asset Bubbles and Their Consequences. The paper discusses how many of the recent asset boom-bust cycles had their origins in an overly accommodative monetary policy. From the summary:

[M]onetary policy has become a source of moral hazard. In acting to counter the economic effects of declining asset prices, the Federal Reserve has come to be viewed as underwriting risky investments. Policy pronouncements by senior Fed officials have reinforced that perception. These actions and pronouncements are mutually reinforcing and destructive to the operation of financial markets. The current financial crisis began in the subprime housing market and then spread throughout credit markets. The new Fed policy fueled the housing boom. Refusing to accept responsibility for the housing bubble, the Fed’s recent actions will likely fuel a new asset bubble.

In a vibrant market economy with technological innovation and ever new profit opportunities, the monetary policy that maintains price stability in consumer goods (or zero price inflation) requires substantial monetary stimulus. That stimulus will have a number of real consequences, including asset bubbles. These asset bubbles have real costs and involve misallocations of capital. For example, by the peak of the tech and telecom boom in March 2000, too much capital had been invested in high-tech companies and too little in “old economy firms.” Too much fiber optic cable and too few miles of railroad track were laid.

By 2002, the Fed was worried about the possibility of price deflation. The experiences of Japan in the 1990s and the Great Depression were clearly weighing on the minds of policymakers. A tilt to stimulus was understandable at the time. A continued bias against deflation will, however, produce a continued bias upward in price inflation. With the bursting of each asset bubble and the fear of deflationary pressure, Fed policy must ease. The inflation rate begins at the positive number. The Greenspan doctrine prescribes a simulative overkill that begins the cycle anew.

This story makes sense to me. As I have argued elsewhere, the Fed's deflation concerns were off the mark by 2003. Deflationary pressures by that time were the result of rapid productivity growth, not weak aggregate demand. The Fed's easing then, pushed the real interest rate below the natural interest rate and set off a Wicksellian disequilibrium. The housing boom was one manifestation of this development.