The Gold Standard  

I have not posted in a long time. It was not meant to be this way. It just happened. Let me break the stalemate with a post on bubbles. Nothing original. It just so happens to be the topic on which I spoke in Mumbai over the weekend. The Indian Alumni Association of the Asian Institute of Management in Manila hosted a panel discussion on ‘Are bubbles necessarily bad?’.

As good friend Nitin Pai – who was in the audience  - rephrased it, the more appropriate question was whether we preferred capitalism with bubbles or socialism. He posed this question to the keynote and valedictory speaker, Mr. Mani Shankar Aiyar. To which, Mr. Aiyar responded, that he preferred capitalism without bubbles. That ideal world, of course, does not exist because bubbles are inherent to human nature. Of course, in an economy organised along socialistic lines, perhaps, there would be a bubble in totalitarian controls. Bubbles have to manifest somewhere, somehow.

There was no speaker to defend bubbles. In the course of my research for this speech, I found that even those who defended the bubbles on account of the risk-taking and innovation (journalist Daniel Gros and Professor Didier Sornette, to name just two) that initially engendered had done so before the latest crisis hit us in 2008. Since then, they have softpedalled. It is difficult to find some one explicitly state that they favour bubbles. No policymaker, not even the American ones, want to be seen in bed with bubbles!

So, whether or not we welcome or like bubbles, the problem is that bubbles not founded on any scientific discovery, technological advancement seem to cause more damage and very little residual positive effects that are now attributed to the Internet and TMT bubbles. Financial capitalism has engendered mostly harmful bubbles and ever since financial sector came to dominate the economic landscape, bubbles have not only become more frequent, they have also become more global and hence, more pervasive in their harmful effects. No wonder even its champions have become more muted.

It was refreshing to see an American policymaker display an attitude of ‘mea culpa’ on their handling of bubbles and their aftermath. I am referring to the recent speech of the President of the New York Fed, Bill Dudley. Just for the record, Bill Dudley is formerly from Goldman Sachs. The full speech is here and the key extracts from the speech on bubbles are given below:

For one, the crisis is provoking a reevaluation of our views on how to respond to asset bubbles. For years, central bank orthodoxy has been that you cannot identify asset bubbles very well. Thus, the strategy has been to move aggressively to clean up such bubbles after they have burst.

I think our level of confidence in that approach has been considerably reduced in the wake of the crisis that we have just experienced. The costs of cleaning up after the fact have been immense.

But make no mistake—developing an effective, more proactive approach is not easy. Among the important questions that need to be answered:

1. How does one identify bubbles—which I’ll define here as persistent large deviations in asset prices from their fundamental value—in real time?
2. What instruments can be used to limit the development of bubbles and/or allow bubbles to deflate in non-catastrophic ways that will not damage the economy in other ways?

Turning to the first issue, identifying asset bubbles in real time is difficult. However, identifying variables that often are associated with asset bubbles—especially credit asset bubbles—may be less daunting. To take one recent example, there was a tremendous increase in financial leverage in the U.S. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. This sharp rise in leverage was observable. Presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a bubble were to burst. This suggests that limiting the overall increase in leverage throughout the system could have reduced the risk of a bubble and the consequences if the bubble were to burst.

Turning to the second issue of how to limit and/or deflate bubbles in an orderly fashion, the fact that increases in leverage are often associated with financial asset bubbles suggests that limiting increases in leverage may help to prevent bubbles from being created in the first place. This again suggests that there is a role for supervision and regulation in the bubble prevention process. For example, it might be appropriate for the Federal Reserve—working with functional regulators such as the SEC (Securities Exchange Commission)—to monitor and limit the buildup in leverage at the major securities firms and the leverage extended from these firms to their clients and counterparties.

Whether there is a role for monetary policy to limit asset bubbles is a more difficult question. On the one hand, monetary policy is a blunt tool for use in preventing bubbles because monetary policy actions also have important consequences for real economic activity, employment and inflation. On the other hand, however, there is evidence that monetary policy does have an impact on desired leverage through its impact on the shape of the yield curve. A tighter monetary policy, by flattening the yield curve, may limit the buildup in leverage.¹

Whether it would be more effective to limit leverage directly by regulatory and supervisory means or via monetary policy is still an open question. But it is becoming increasingly clear that a totally hands off approach is problematic. [More here]