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ASSET PRICE BUBBLES: New research on the tough choices facing central bankers

Central bankers face a trade-off in the face of high and rising asset prices, according to research by John Conlon, published in the February 2015 issue of the Economic Journal. They can follow a policy of bursting bubbles in an attempt to protect less sophisticated investors from unwarranted price movements. If this policy is successful, then investors can trade with greater confidence and resources will be allocated more efficiently across the economy.

But if central banks do follow such a policy, Professor Conlon warns that there is a potential downside: ''Anything they do will move markets. In fact, even inaction may move markets if this inaction is interpreted as agreement with current asset prices.''

Should central banks burst asset price bubbles? If they can identify bubbles, who gains and who loses from a bubble-bursting policy? Will central banks be able to protect less-informed investors from unwarranted price movements? And is there a danger that investors might rely too much on central banks to burst such bubbles?

Until recently, economists lacked the tools even to think logically about such questions. In the past, the only way that economists could make any kind of sense of bubbles was by using theories in which bubbles lasted forever. This made bubble assets essentially riskless. In fact, these theories suggested that bubbles actually made everyone better off, by providing additional assets that people could trade with each other.

But in the past decade or two, economists have begun to develop more realistic analyses of bubbles. These newer approaches are essentially ''greater fool'' theories of bubbles, according to which, bubble investors know that they are taking risks by holding overpriced assets. They know that they are ''fools'' to hold the assets. But these initial fools hope to be able to sell the assets to ''greater fools'' before prices collapse.

These newer theories often depend on ''asymmetric information'': the original fools hope that they have an informational advantage over the greater fools. This means that bubble policy becomes an issue of information management by policy-makers.

For example, if the US Federal Reserve chair Janet Yellen is considering a bubble-bursting policy, she must ask herself what she knows that investors might not know. Are there sophisticated investors who know more than she does? Does she, in turn, know more about asset values than the less sophisticated, greater fool investors?

And if she pursues a bubble-bursting policy, can she protect these less sophisticated investors from the more sophisticated investors? Can she protect the ''greater fools'' from the more sophisticated initial fools who hope to exploit them?

 

The new study suggests that central banks can potentially protect greater fools from more sophisticated investors. But there''s a catch: suppose that investors expect central banks to follow a policy of bursting bubbles. Then if asset prices are high and the central bank does not try to deflate them, investors may interpret this as an endorsement of the high prices, which might push them even higher.

This can actually be a good thing if the high prices are justified by fundamentals. In this case, investors can trade assets with more confidence, and resource allocation becomes more efficient.

But if assets are overpriced, then central bank inaction can make the overpricing worse. As Andrew Filardo of the Bank for International Settlements wrote in 2004: ''if the monetary authority chose not to state a position on whether there is a bubble, the public might interpret this as tacitly endorsing the notion that there is no bubble. That action by itself could reinforce factors driving the bubble.''

Policy-makers may therefore be reluctant to become ''arbiter[s] of security speculation or values'', as suggested by the Federal Reserve in 1929.

 

''Should Central Banks Burst Bubbles? Some Microeconomic Issues'' by John Conlon is published in the February 2015 issue of the Economic Journal. John Conlon is at the University of Mississippi.