In a Wonkblog post Matt O'Brien discusses central bank efforts to deal with bubbles. His starting point is the decision by the central bank in Sweden to begin raising interest rates in 2010, ostensibly to head off the development of a bubble there.

There are two points worth noting here. First, it is difficult to imagine what the central bankers were drinking in Sweden when they decided to start shooting at bubbles. A bubble that threatens the economy is a bubble that moves the economy. If there is a bubble in Uber stock or the price of hops, there is little consequence to the economy when the bubbles burst.

The crashes of the stock bubble and the housing bubble led to recessions because these bubbles were driving the economy. This was easy to see in the data in both cases. In the first case, the investment share of GDP hit the highest level in more than two decades as people were able to raise billions in IPOs for utterly nonsense dot.coms. Consumption surged to then record shares of income as the stock wealth effect caused spending to surge. This boost to the economy disappeared when the bubble burst.

There was a similar story with the housing bubble. Residential construction hit a record share of GDP, roughly 50 percent above its average over the prior two decades. Consumption surged to an even higher share of income, driven by the housing wealth effect. And, when this bubble burst we got the Great Recession.

There were no obvious distortions in the Swedish economy when its central bank started shooting at bubbles. Its savings rate was relatively high and the country had a huge trade surplus (as opposed to deficits in bubble driven economies like the U.S. and Spain). The bubbles that really matter are not hard to see. Economists like to pretend otherwise since almost all of them missed the last one, but that reflects the competence of economists, not the inherent difficulty in recognizing bubbles.

The other point is that central banks do have many tools other than interest rates to attack bubbles. My favorite is talk.

I know it doesn't sound sophisticated and it's not terribly mathematical, but I suspect it would have a very large impact on the housing market if Janet Yellen were to say that she thought house prices were over-valued and that the Fed would be prepared to take steps to bring prices in line with fundamentals. Note that I am referring to an explicit warning backed up by Fed research, not a mumbled "irrational exuberance" subsequently qualified by incoherent gibberish. I would certainly take such a warning seriously if I was thinking of buying a house.

I know this view is dismissed by economists, but it's hard to see the downside of trying this path. The worst I've heard is that this could damage the Fed's credibility if house prices didn't fall. Given that we have lost many trillions of dollars of output and millions of people have seen their lives ruined from the collapse of the housing bubble and the ensuing recession, the risk of the Fed's credibility seems a small price to pay in such circumstances.

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