The Importance of Central Bank Intervention regarding Asset Bubbles 

Bernanke and Gertler concluded asset bubbles as practically impossible to identify beforehand and that “monetary policy is not by itself a sufficient tool to contain the potentially damaging effects of booms and busts in asset prices” (Bernanke & Gertler, 1999). Throughout this literature review I will analyse and compare the significance of central bank intervention in respects to asset bubbles as well as examine additional published papers that might oppose the argument for central bank intervention in regard to asset bubbles.

Allen and Gale have published a paper titled Bubbles and Crises where they discuss the causes of asset bubbles. They state that asset bubbles arise from the “inability of lenders to observe how risky borrowers’ investments are” (Allen & Gale, 2000) which is an example of the agency theory problem where the agent, in this case the investors, invest into risky assets such as real estate and stocks that drive up the price of the asset more than the underlying value in order to receive an attractive return.

However, the investors realise they can escape huge losses by defaulting on their loans leading to the risk being shifted on to the principle, which are the banks. Allowing to divert the risk on to the banks is an act of moral hazard that investors take in order to take advantage of the central bank’s low interest rates due to the central bank’s credit expansion. Allen and Gale also specified that the central bank should be held accountable for controlling these bubbles through their monetary policy by limiting the amount of credit provided in order to restrict asset prices rising over their real value and in turn avoid financial fragility by having higher interest rates in order to prevent the asset bubble from bursting (Allen & Gale, 2000).

Gurkaynak rejects the idea that central bank should be held responsible for asset bubbles as it is difficult to detect asset bubbles. Gurkaynak explained in his journal called Economic Tests of Asset Price Bubbles that asset bubbles are hard to distinguish through surveys of econometric tests of asset price bubbles. This is mainly because the bubbles cannot be realised with a reasonable level of confidence as there is a theoretical concern due to the fact there are papers with empirical evidence that oppose asset bubbles existing. In retrospection, central bank intervention is not particularly necessary in order to manage an asset bubble as there is inconsistencies in the data from bubble detection tests to prove if asset bubbles even exist as it can be suggested that price inflation may be due to the natural economic cycle where the economy is currently facing high growth in output (Gurkaynak, 2008).

Scheinkman and Xiong wrote an article in a journal titled Overconfidence and Speculative Bubbles that rationalises a continuous-time equilibrium model. This model aligns with the agency theory problem where overconfidence creates disagreements between parties which is also consistent in Allen and Gale’s risk shifting model. Scheinkman and Xiong highlight that Tobin’s tax is an effective scheme used to considerably reduce speculative trading when transaction costs are minimal. However, the magnitude of the effect is limited on the size of the asset bubble as Scheinkman and Xiong may agree with Bernanke and Gertler that “monetary policy is not by itself a sufficient tool to contain asset prices” (Bernanke & Gertler, 1999) as fiscal policies such as Tobin’s tax can aid in reducing the size of the asset bubble alongside monetary policy (Scheinkman & Xiong, 2003).

Santos and Woodford’s main discoveries show that asset bubbles are non-existent under general economic conditions of the free market. They state that assets that are sufficiently productive will result in a positive net supply allowing for asset bubbles to deflate as the free market will correct itself due to the law of demand and supply as rationalised by Milton Friedman as little to no central bank intervention is required in order to prevent an asset bubble. However, the author’s do mention that when there is an uncompetitive market, asset bubbles can exist under special circumstances where the central bank is financially fragile due to expansionary monetary policy. They claim that in order for the free market to work effectively, the central bank does not need to intervene as they could potentially cause more harm than good. There is a common theme of asset bubbles not existing between both Santos and Woodford’s findings and Gurkaynak where both ideologies stem from Friedman’s stance on the free market correcting itself (Santos & Woodford, 1997).

Patel also addresses the need for central bank intervention in her article. Patel encourages central bank intervention through monetary policy in managing asset bubbles before they burst and have negative effects on the economy. Patel uses the 2008 financial crises as an example for central banks to learn from their mistakes and in turn, prevent and manage asset bubbles in case they burst even though central banks have made advancements in transparency and improving price stability when making policy decisions.

Patel highlights this fact when in 1977, the United States Federal Reserve implemented a dual mandate of stabilising asset prices simultaneously with maximising employment through the use of monetary policy. However, Patel suggests that the Federal Reserve needs to consider containing asset bubbles in their macroeconomic objectives when setting out monetary policies as an expansionary monetary policy could negatively impact the asset bubble causing asset prices to inflate as the central bank needs to recognise the fundamental value of the asset and create as medium between increased output and stabilised prices of assets. Patel understands that action from more than the central bank alone is essential for a more financially stable economy as responsibility is weighted on regulators and financial institutions too (Patel, 2010).

Palley believes that central bank intervention is necessary in order to prevent asset bubbles from bursting as Palley introduced the notion of asset-based reserve requirements (ABRR). This concept allows for additional reserve requirements for each asset class such as mortgage securities and shares. In theory, the central bank could potentially increase the requirement rate from zero if they could identify an asset bubble. This would result in interest rates being unchanged as the cost of holding on to the specific asset would increase.

Leaving interest rates unchanged allows for the central bank to maintain their economic targets for the economy while specifically targeting an asset bubble such as the real estate market by increasing reserve requirements on new mortgages. This results in containing the housing bubble as it would be less attractive for investors to purchase any real estate whilst leaving constructive investment more attractive. However, Palley revealed that this is all dependent on new quantitative regulation in order to support the central bank. Palley’s suggestion correlates with Patel’s understanding of that the central bank should consider the asset bubbles when planning monetary policies (Palley, 2003).

Having reviewed literature arguing for and against central bank intervention, it can be presumed that the central bank should be held partially accountable for preventing and containing asset bubbles spilling into the economy causing negative repercussions as experienced in the 2008 financial crisis. This can be justified as linking back to Bernanke and Gertler mentioning that “monetary policy is not by itself a sufficient tool to contain the potentially damaging effects of booms and busts in asset prices” (Bernanke & Gertler, 1999).

Scheinkman and Xiong also supports the ideology that monetary policy alone is not sustainable as fiscal policy together with monetary policy could potentially reduce the size of an asset bubble. Although, this is all contingent whether or not an asset bubble can be initially identified as examined by Gurkaynak as well as Santos and Woodford. Ultimately, Palley and Patel’s understanding of central bank intervention demonstrates clearly that it should not be the role of the central bank alone to intervene to prevent asset bubbles, nevertheless it requires the assistance of regulators and other financial institutions to support the deflation of asset bubbles.