interest rates will produce better outcomes. for instance, william white, of the bank for international settlements, has said that " monetary policy might rather be used in a highly discretionary way to respond to growing imbalances that were judged by policymakers to threaten financial instability. " 2 although central banks have generally not argued that interest rates should be raised aggressively to burst asset price bubbles, statements suggest some central bankers believe some leaning against the wind might be warranted. for example, in the second half of 2003 and the first half of 2004, a minority of members of the monetary policy committee of the bank of england argued for raising interest rates more than could be justified in terms of the bank of england's objectives for inflation over its normal policy horizon. they said that such a move would help lower the probability of house prices rising further and make it less likely that a house price collapse would occur later. mervyn king, the governor of the bank of england, did not advocate leaning against the wind but did suggest that, to prevent a buildup of financial imbalances, a central bank might extend the horizon over which inflation is brought back to target. statements from officials at the european central bank also have suggested that the possibility of an asset boom or bust might require longer than the usual one to two years in assessing whether the price stability goal was being met. the recent case of the sveriges riksbank, the swedish central bank, is particularly interesting. i studied the riksbank in a report on monetary policy written with francesco giavazzi for the swedish parliament before i came to the federal reserve board. 3 we found that communications by the riksbank suggested to market participants that it was actually adjusting monetary policy to lean against the wind of rapid increases in home prices. on february 23, 2006, the executive board of the riksbank voted to raise the repo rate 25 basis points ( 0. 25 percentage points ). this monetary policy action was accompanied by a statement acknowledging that the inflation forecast was revised downward. in fact the inflation report published on the same day also showed that inflation forecasts had been revised downward and were below the 2 percent target at every horizon. the executive board's statement pointed out that " there is also reason to observe that household indebtedness and house prices are continuing to rise rapidly. " 4 it then said : " given this, the executive board decided to raise the repo rate by 0. 25 percentage points at yesterday's meeting

recent notable example among industrial countries being that of japan. in principal, in the event of such a crash, monetary policy might become less effective in restoring the economy's health. yet there are several reasons to believe that this concern about burst bubbles may be overstated. to begin with, the bursting of asset price bubbles often does not lead to financial instability. in research that i conducted with eugene white on fifteen stock market crashes in the twentieth century, we found that most of the crashes were not associated with any evidence of distress in financial institutions or the widening of credit spreads that would indicate heightened concerns about default. 5 the bursting of the recent stock market bubble in the united states provides one example. the stock market drop in 2000 - 01 did not substantially damage the balance sheets of financial institutions, which were quite healthy before the crash, nor did it lead to wider credit spreads. at least partly as a result, the recession that followed the stock market drop was very mild despite some severely negative shocks to the u. s. economy, including the september 11, 2001, terrorist attacks and the corporate accounting scandals in enron and other u. s. companies ; the scandals raised doubts about the quality of information in financial markets and ultimately did indeed widen credit spreads. there are even stronger reasons to believe that a bursting of a bubble in house prices is unlikely to produce financial instability. house prices are far less volatile than stock prices, outright declines after a run - up are not the norm, and declines that do occur are typically relatively small. the loan - to - value ratio for residential mortgages is usually substantially below 1, both because the initial loan is less than the value of the house and because, in conventional mortgages, loan - to - value ratios decline over the life of the loan. hence, declines in home prices are far less likely to cause losses to financial institutions, default rates on residential mortgages typically are low, and recovery rates on foreclosures are high. not surprisingly, declines in home prices generally have not led to financial instability. the financial instability that many countries experienced in the 1990s, including japan, was caused by bad loans that resulted from declines in commercial property prices and not declines in home prices. in the absence of financial instability, monetary policy should be effective in countering the effects of a burst bubble. many have learned the wrong lesson from the japanese experience. the problem in japan was not so much the bursting of the bubble but rather the policies that followed. the problems