In a post for Juncture, IPPR's Journal of Politics, economist Dean Baker, co-director of the Center for Economic and Policy Research, wrote a memo on how he would advise Mark Carney, the incoming governor of the Bank of England.
Since you’re no doubt getting a great deal of advice about how to address the current downturn, let me step back and look at the longer-term picture. Central bankers, including your predecessor, have fallen down on the job by not taking asset bubbles seriously. Contrary to the folklore that was popular during the days of the ‘Great Moderation’, it is not easy to clean up the mess after an asset bubble has burst.
Collapsed asset bubbles are likely to lead to periods of prolonged weakness, as we are now seeing in the UK, the eurozone and the United States. The basic point is simple: large asset bubbles distort the economy. In the case of the housing bubbles that afflicted most wealthy countries in the last decade, these led to excessive building and extraordinary levels of consumption through the housing wealth effect. There is no easy way to replace these sources of demand when a bubble bursts.
This means that it is incumbent on central banks to prevent the growth of dangerous bubbles. Higher interest rates are one possible tool, but it is worth trying less-drastic steps first.
The initial route is simple: talk. Central banks have the public’s ear. If they not only argue for the existence of a bubble but carefully document the case with research as well, it will be harder for the public to laugh off the evidence. This may not work, but what’s the downside? Talk is cheap.
Second, there are regulatory tools that can be used to try to stem the flow of finance that fuels a bubble. These should be used to their fullest possible extent.
Higher interest rates are a last resort, but are certainly preferable to the alternative, allowing bubbles to grow as large as those we saw in the last decade.
Targeting 2.0 per cent inflation is something that only matters to economics nerds and bankers – bubble-fighting is an agenda that makes a difference for the whole country.