Frederic S Mishkin: How should we respond to asset price bubbles?
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Wharton Financial Institutions Center and Oliver Wyman Institute's
Annual Financial Risk Roundtable, Philadelphia, Pennsylvania, 15 May 2008.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website (www.federalreserve.gov)
* * *
Over the centuries, economies have periodically been subject to asset price bubbles -
pronounced increases in asset prices that depart from fundamental values and eventually
crash resoundingly. Because economies often fare very poorly after a bubble bursts, central
bankers need to think hard about how they should address such bubbles. This issue has
become especially topical of late because of the rapid rise and subsequent decline in
residential housing prices this decade. The recent drop in house prices in many markets
around the country has been accompanied by increasing rates of defaults on mortgage loans
and home foreclosures. These developments have created hardship for the families who are
forced to leave their homes and have disrupted communities; in addition, the developments
have contributed to a major shock to the financial system, with sharp increases in credit
spreads and large losses to financial institutions. As many have pointed out, the damage to
households' credit and the financial disruption have been a drag on the U.S. economy, which
has led to a slowing of economic growth and a recent decline in employment.
In my remarks today, I would like to return to the issue of how we should respond to possible
asset price bubbles.1 I will first focus on the conceptual framework I use to evaluate these
issues, based on a core set of scientific principles for monetary policy.2 My framing of the
issues highlights the following three questions:
• Are some asset price bubbles more problematic than others?
•
How should monetary policy respond to asset price bubbles? and
•
What other types of policy responses are appropriate?
My discussion of these conceptual issues is followed by a summary of several historical
examples that illustrate the importance of focusing on the principles I have outlined. As
usual, these remarks reflect only my own views and are not intended to reflect those of the
Federal Open Market Committee or of anyone else associated with the Federal Reserve
System.
Are some asset price bubbles more problematic than others?
In order to consider how monetary and other policies should address asset price bubbles, we
must first examine how asset prices influence inflation and aggregate economic activity.
These influences act through several channels; in particular, asset prices provide signals
regarding profitable investments, affect the wealth of households, and influence the cost of
capital to firms and households. For example, higher equity prices, whether driven by
fundamentals such as lower interest rates or faster productivity growth or by bubble-type
factors like "irrational exuberance," boost business investment by lowering the cost of capital
and raise household demand by generating increased wealth. Other fluctuations in asset
prices act similarly. The resulting fluctuations in resource utilization lead to changes in
inflation.3
The influences of asset prices on demand and inflation through traditional wealth and
cost-ofcapital channels fall directly within the traditional concerns of monetary policy, a point to
which I will return shortly. However, not all asset price bubbles are alike, and some bubbles
raise issues outside the direct responsibility of monetary policy but within the policy concerns
of the broader regulatory framework governing our financial system. In particular, some asset
price bubbles can have more-significant economic effects, and thus raise additional concerns
for economic policymakers, by contributing to financial instability. Financial history reveals
the following typical chain of events: Because of either exuberant expectations about
economic prospects or structural changes in financial markets, a credit boom begins,
increasing the demand for some assets and thereby raising their prices.4 The rise in asset
values, in turn, encourages further lending against these assets, increasing demand, and
hence their prices, even more. This feedback loop can generate a bubble, and the bubble
can cause credit standards to ease as lenders become less concerned about the ability of
the borrowers to repay loans and instead rely on further appreciation of the asset to shield
themselves from losses.
At some point, however, the bubble bursts. The collapse in asset prices then leads to a
reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the
demand for the assets declines further, and prices drop even more. The resulting loan losses
and declines in asset prices erode the balance sheets at financial institutions, further
diminishing credit and investment across a broad range of assets. The decline in lending
depresses business and household spending, which weakens economic activity and
increases macroeconomic risk in credit markets.5 In the extreme, the interaction between
asset prices and the health of financial institutions following the collapse of an asset price
bubble can endanger the operation of the financial system as a whole.6
To be clear, not all asset price bubbles create these risks to the financial system. For
example, the bubble in technology stocks in the late 1990s was not fueled by a feedback
loop between bank lending and rising equity values; indeed, the bursting of the tech-stock
bubble was not accompanied by a marked deterioration in bank balance sheets. But potential
for some asset price bubbles to create larger difficulties for the financial system than others
implies that our regulatory framework should be designed to address the potential challenges
to the financial system created by these bubbles.
How should monetary policy respond to asset price bubbles?
In order to think about how central banks should respond to asset prices, we need to first
remember the objectives of monetary policy. The ultimate purpose of a central bank should
be to promote the public good through policies that foster economic prosperity. Research in
3
Of course, asset price bubbles have additional implications for economic efficiency. Departures of asset prices
from levels implied by economic fundamentals can lead to inappropriate investments that decrease the
efficiency of the economy by diverting resources toward economic activities that are supported by the bubble
(for example, see Dupor, 2005). For example, during the bubble in tech stocks in the late 1990s, there was
overinvestment in some types of high-tech infrastructure. Similarly, the bubble in housing prices led to too
many houses being built. These distortions to activity across sectors of the economy are a drag on efficiency
and hence are a matter of concern above and beyond fluctuations in overall economic activity and inflation.
4
See, for example, Mishkin (1991) and Kindleberger (2000).
5
I have previously discussed the interaction of financial markets and macroeconomic risk (for example,
Mishkin, 2007d, 2007e).
6
See my earlier remarks on the subject (Mishkin, 2007c).
BIS Review 61/2008
monetary economics describes this objective in terms of stabilizing both inflation and
economic activity. Indeed, these objectives are exactly what is embodied in the dual mandate
that the Congress has given the Federal Reserve.7
Because of their effects on prices and employment, macroeconomic fluctuations due to asset
price movements are a concern for monetary policy makers. However, the macroeconomic
consequences of asset price fluctuations are unlikely to have long-lasting and severe
consequences for the economy as long as monetary policy responds appropriately. Whether
an asset price bubble is occurring or not, as asset prices rise and boost the outlook for
economic activity and inflation, monetary policy should respond by moving to a more
restrictive stance. After a bubble bursts and the outlook for economic activity deteriorates,
policy should become more accommodative.8 As I pointed out in a paper that I presented at
the Federal Reserve Bank of Kansas City's Jackson Hole conference in September, if
monetary policy responds immediately to the decline in asset prices, the negative effects
from a bursting asset price bubble to economic activity arising from the decline in wealth and
increase in the cost of capital to firms and households are likely to be small.9 More generally,
monetary policy should react to asset price bubbles by looking to the effects of such bubbles
on employment and inflation, then adjusting policy as required to achieve maximum
sustainable employment and price stability.
To be clear, I think that in most cases, monetary policy should not respond to asset prices
per se, but rather to changes in the outlook for inflation and aggregate demand resulting from
asset price movements. This point of view implies that actions, such as attempting to "prick"
an asset price bubble, should be avoided.
I take this view for (at least) three important reasons.10 First, asset price bubbles can be hard
to identify. As a result, tightening monetary policy to restrain a bubble that has been
misidentified can lead to weaker economic growth than is warranted. In addition, central bank
actions to influence asset prices when the central bank is uncertain about the presence or
extent of a bubble can interfere with the role of asset prices in allocating resources.11
Second, even if asset price bubbles could be identified, the effect of interest rates on asset
price bubbles is highly uncertain. Although some theoretical models suggest that raising
interest rates can diminish the acceleration of asset prices, raising interest rates may be very
ineffective in restraining the bubble, because market participants expect such high rates of
return from buying bubble-driven assets.12
Other research and historical examples (which I
will discuss later) have suggested that raising interest rates may cause a bubble to burst
more severely, thereby increasing the damage to the economy.13 Another way of saying this
is that bubbles are departures from normal behavior, and it is unrealistic to expect that the
7
The Federal Reserve's congressional mandate is actually couched in terms of three goals: maximum
employment, stable prices, and moderate long-term interest rates. However, as I have discussed (Mishkin,
2007a), the mandate is more appropriately interpreted in terms of the dual goals of price stability and
maximum sustainable employment, and this formulation is what is consistent with stabilizing both inflation and
economic activity. Mishkin (2008) discusses how the pursuit of price stability can foster maximum sustainable
employment.
8
Vice Chairman Kohn (2006) presented similar views on the response of monetary policy to asset prices.
9
See Mishkin (2007g).
10
An additional reason is that many crashes of asset prices which have become associated with asset price
bubbles have had very limited affects on the economy. In a paper I wrote with Eugene White (Mishkin and
White, 2003), we studied 15 stock market crashes that occurred in the United States from 1900 to 2001 and
found that in most cases they were not followed by episodes of financial instability.
11
Chairman Bernanke (2002) has discussed this potential problem.
12
For example, see the discussion in Greenspan (2002).
13
For example, see Gruen, Plumb, and Stone (2005).
BIS Review 61/2008
usual tools of monetary policy will be effective in abnormal conditions. The bottom line is that
we do not know the effects of monetary policy actions on asset price bubbles.
Third, there are many asset prices, and at any one time a bubble may be present in only a
fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as
such actions would be likely to affect asset prices in general, rather than solely those in a
bubble.
All told, research suggests that monetary policy that does not try to prick bubbles, but instead
responds solely to the inflation and aggregate demand outlook, is likely to lead to better
outcomes even when bubbles might arise.14
Are other types of policy responses appropriate?
I would now like to return to the effect of asset price bubbles on the stability of the financial
system. As I highlighted earlier, some, but clearly not all, asset price bubbles create risks to
the financial system that could have large negative effects on the macroeconomy. As a
result, it is important to examine the potential for government policies to address the type of
bubble in which there is feedback between asset prices and financial stability. I would like to
emphasize the importance of regulatory policy. Monetary policy - that is, the setting of
overnight interest rates - is already challenged by the task of managing both price stability
and maximum sustainable employment. As a result, it falls to regulatory policies and
supervisory practices to help strengthen the financial system and reduce its vulnerability to
both booms and busts in asset prices.
Of course, some aspects of such policies are simply the usual elements of a well-functioning
prudential regulatory and supervisory system. These elements include adequate disclosure
and capital requirements, prompt corrective action, careful monitoring of an institution's
riskmanagement procedures, close supervision of financial institutions to enforce compliance
with regulations, and sufficient resources and accountability for supervisors.
More generally, our approach to regulation should favor policies that will help prevent future
feedback loops between asset price bubbles and credit supply. A few broad principles are
helpful in thinking about what such policies should look like. First, regulations should be
designed with an eye toward fixing market failures. Second, regulations should be designed
so as not to exacerbate the interaction between asset price bubbles and credit provision. For
example, research has shown that the rise in asset values that accompanies a boom results
in higher capital buffers at financial institutions, supporting further lending in the context of an
unchanging benchmark for capital adequacy; in the bust, the value of this capital can drop
precipitously, possibly even necessitating a cut in lending.15 It is important for research to
continue to analyze the role of bank capital requirements in promoting financial stability,
including whether capital requirements should be adjusted over the business cycle or
whether other changes in our regulatory structure are necessary to ensure macroeconomic
efficiency.16 Finally, in general, regulatory policies are appropriately focused on the
soundness of individual institutions. However, during certain periods, risks across institutions
become highly correlated, and we need to consider whether such policies might need to take
account of these higher-stress environments in assessing the resilience of both individual
institutions and the financial system as a whole in the face of potential external shocks.
Some policies to address the risks to financial stability from asset price bubbles could be
made a standard part of the regulatory system and would be operational at all times -
whether a bubble was in progress or not. However, because specific or new types of market
failures might be driving a particular asset price bubble, some future bubbles will almost
certainly create unanticipated difficulties, and, as a result, adjustments to our policy stance to
limit the market failure contributing to a bubble could be very beneficial if identified and
implemented at the appropriate time.
Earlier, I pointed out that a bubble could be hard to identify. Indeed, I think this is especially
true of bubbles in the stock market. Central banks or government officials are unlikely to
have an informational advantage over market participants. If a central bank were able to
identify bubbles in the stock market, wouldn't market participants be able to do so as well? If
so, then a bubble would be unlikely to develop, because market participants would know that
prices were getting out of line with fundamentals.
However, although I believe that stock market bubbles might be hard to identify because they
are typically not driven by credit booms (which also makes them less harmful because their
collapse is less likely to lead to financial instability), when asset prices are rising rapidly at
the same time that credit is booming, there may be a greater likelihood that asset prices are
deviating from fundamentals, because laxer credit standards may be driving asset prices
upward.17 In this case, financial regulators at central banks and other institutions may have a
greater likelihood of identifying that a bubble is in progress; for example, they might have
information that lenders have weakened their underwriting standards and that credit
extension is rising at abnormally high rates.
The reasoning here suggests that a rapid rise in asset prices accompanied by a credit boom
provides a signal that should lead central bankers and other financial supervisors to carefully
scrutinize financial developments to see if market failures might be driving the asset price
boom. The resulting analysis of financial developments might then lead policymakers to
consider implementing policies to address the imperfections behind the market failures and
thereby help reduce the magnitude of the bubble.
Some historical examples
I would like to now turn to a few examples from U.S. history and international experience that
highlight the interaction between asset price bubbles, financial stability, and the policy
framework.
The stock market boom of the 1920s
The Roaring Twenties and the onset of the Great Depression present a particularly drastic
example. The U.S. economy thrived during the 1920s as new technologies, financial
innovations, and improved business practices were introduced and contributed to a general
sense of optimism. As you all know, the stock market experienced a dramatic rise during that
decade until it burst during the Great Crash of 1929.
A popular account of that period attributes the stock market boom to easy credit and rising
speculation; the period ended with panic selling on Wall Street and triggered the beginning of
the Great Depression.18 According to this view, the Federal Reserve was incorrect in letting
the rise in equity prices develop and should have raised interest rates to stem stock market
speculation. You will guess from my proposed set of principles for monetary policy that I view
this approach as mistaken.
It is first very difficult to assess the extent to which the stock market was driven by
nonfundamental forces at the time; by some accounts, the stock market bubble started only
in March 1928.19 Nonetheless, the rise in equity prices took a more prominent place during
policy discussions at the Fed beginning in 1927, with Board member Adolph Miller pressing
fervently for an increase in interest rates to stop the speculative use of credit. This approach
was opposed by Benjamin Strong, the influential Governor of the Federal Reserve Bank of
New York who feared a negative impact on the economy: "...any effort through higher rates
directed especially at stock speculation would have an unfavorable effect upon business..."20
However, Strong's death in 1928 opened the door for a more restrictive monetary policy
aimed at curbing excesses in the stock market, even as signs of economic weakness
became visible.
The tightening cycle that ended in August 1929 weakened an already deteriorating economy
and paved the way for the collapse of the stock market in October. The Federal Reserve's
mistake in attempting to burst the bubble directly was made worse by its refusal to change
course rapidly after the market collapsed and the banking system got into trouble, thereby
allowing deflation to set in, which raised real interest rates to extremely high levels and
further depressed growth.
Japan's asset price boom and the lost decade
An asset price bubble also confronted the Bank of Japan (BOJ) with tough decisions starting
in the mid- to late 1980s. The extent of the asset price boom in Japan in the late 1980s can
be gauged by the fact that the land surrounding the Imperial Palace in Tokyo was estimated
to be worth more than the whole of California at that time. Without a doubt, the 1980s was a
prosperous decade in Japan with high growth, low unemployment, little inflation, and an
envied business model. During that decade, equity prices rose more than 600 percent and
land prices boomed more than 400 percent.
Soaring equity and land prices during the 1980s, combined with relatively low interest rates,
eased financing conditions for investment substantially.21 The ratio of bank loans to gross
domestic product surged, and investment spending became the main driver of economic
activity. Because of financial deregulation, banks' risk-taking behavior also increased as they
channeled more funds to real-estate-related sectors and to small firms, accepting property as
collateral.22 Trusting in a rising real estate market, some banks went as far as lending more
than 100 percent of a property's appraisal value.
As at the Fed during the Roaring Twenties, the BOJ was concerned about the rapid rise in
asset prices in the mid-1980s and the possibility that a bubble was in progress. In 1989, as
asset prices continued to soar and inflation moved upward, the BOJ decided to start raising
rates. The stock market collapsed at the beginning of 1990, but land prices continued to rise,
and the BOJ kept tightening policy. Monetary policy only gradually reversed course in the
summer of 1991 as growth declined and inflation and land prices started to move down. The
subsequent decade has been termed "the lost decade." During that time, Japan suffered
from anemic growth and repeated bouts of very low inflation and deflation.
Japan's experience re-emphasizes the importance of regulatory policies that may prevent
feedback loops between asset price bubbles and credit provision. Indeed, during the boom,
Japanese regulations that allowed banks to count as capital unrealized gains from equities
may have contributed to banks' appetite for equities during the stock market run-up and to
financial instability as the stock market collapsed. After the bursting of the bubble,
policymakers did not quickly resolve the fragility of the banking sector, thereby allowing
conditions to worsen as banks kept lending to inefficient, debt-ridden, so-called zombie firms.
On the other hand, Japan's experience does not support the need for preemptive monetary
policy actions to deflate a bubble, as some commentators have suggested.23 The tightening
of monetary policy during the bubble period does not appear to have led to better economic
outcomes. Moreover, the BOJ did not reverse course sufficiently or rapidly enough in the
aftermath of the crisis.24 Research suggests that it was the slow response of monetary policy
to the deterioration in the economic outlook and fall in inflation following the bursting of the
bubble that contributed to the onset of deflation.25
The recent U.S. experience
As highlighted in my introduction, the issues I have discussed today are especially salient
because of the recent experience with house prices in the United States. It is too early to
draw firm conclusions regarding all of the factors that have contributed to the rise and decline
of house prices and the impact of these developments on our financial system and the
macroeconomy. But the Federal Reserve and other government agencies have already
begun to address some weaknesses that emerged during this period. For example, problems
arose in recent years in the chain linking the origination of mortgages to their distribution to
investors through structured investment products like mortgage-backed securities.
Underwriting standards became increasingly compromised at origination. In retrospect, the
breakdown in underwriting can be linked to the incentives that the originate-to-distribute
model, as implemented in this case, created for the originators. Notably, the incentive
structures often tied originator revenue to loan volume rather than to the quality of the loans
being passed up the chain. This problem was exacerbated by the bubble in house prices:
Lenders began to ease standards as further appreciation in house prices was expected to
ensure that risk was low, and investors failed to perform the research necessary to fully
appreciate the risks in their investments, instead relying on further house price appreciation
to prevent losses. The interaction between lenders' and investors' views and house prices
illustrates the pernicious feedback loop I highlighted earlier.
These problems became apparent only in retrospect, in part, because the growth of the
originate-to-distribute model for mortgages was an ongoing innovation in financial markets;
as a result, neither the market nor regulators had sufficient information for evaluating the
nature of the risks involved. Looking forward, efforts to improve scrutiny of the processes that
originators use and the incentives they face, better information for consumers, improved
performance of the credit rating agencies, and a number of other reforms that have been
recommended by the President's Working Group on Financial Markets will be important in
preventing a future bubble like that in the most recent experience - steps highlighted by
Chairman Bernanke in remarks earlier this year.26
Conclusion
Let me conclude by reiterating the main points of the analysis here. First, not all asset price
bubbles are alike. Asset price bubbles that are associated with credit booms present
particular challenges, because their bursting can lead to episodes of financial instability that
have damaging effects on the economy.
Second, monetary policy should not try to prick possible asset price bubbles, even when they
are of the variety that can contribute to financial instability. Just as doctors take the
Hippocratic oath to do no harm, central banks should recognize that trying to prick asset
price bubbles using monetary policy is likely to do more harm than good. Instead, monetary
policy should react to asset price bubbles by looking to the effects of asset prices on
employment and inflation, then adjusting policy as required to achieve maximum sustainable
employment and price stability. This monetary policy response should prove sufficient to
prevent adverse macroeconomic effects of some types of asset price bubbles.
Third, because asset price bubbles can arise from market failures that lead to credit booms,
regulation can help prevent feedback loops between asset price bubbles and credit
provision. Our regulatory framework should be structured to address failures in information or
market incentives that contribute to credit-driven bubbles. Moreover, we should aim to
monitor the health of the financial system overall and ensure that our regulatory approach
takes account of risks across institutions that are highly correlated and thus affect the
strength of the financial system as a whole.
We have learned many lessons from past experience in the United States and in other
countries, and I am confident that continued research in these areas will help us address the
new tests that will undoubtedly arise as financial innovation and the evolving structure of our
financial markets present new challenges.
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