Central banks and bubbles: Prevention or cure?

The RBI has stepped on many tails by raising the cash reserve ratio of banks effective from December 23. This means that from that date onwards they can lend less than they have been lending. This has been done because the RBI has been fretting about inflation, especially about the high prices of assets like stocks and land.

But, some people ask, is it any of the RBI's business to prick asset price bubbles? More generally, should central banks assume that there is a bubble and proceed to prick it? Bubbles are usually caused by too much money -- made available by too much lending by banks (and others) -- chasing too few assets. Hence the RBI's intervention to reduce at least bank credit, even if it can't do anything about the black money which is created mainly because of the finance ministry's policies.

Be that as it may, earlier this year, there were two papers on the subject of central banks and bubbles. One, by Nouriel Roubini of Roubini Economics, which said central banks should -- indeed must -- prick bubbles and the other, by Adam S Posen, a senior fellow at the Institute for International Economics, said they should not because bubbles can be caused by many factors, not just monetary ones.

Roubini's (several) arguments are based on the notion that central banks should prevent bubbles from bursting rather than merely react after they burst to limit the damage. The opposite view, says Roubini, "...implies an asymmetric response to bubbles: no reaction on the way up, but aggressive monetary easing when they burst to contain the collateral damage". Roubini also says that economic theory "supports the idea of a monetary targeting of asset prices and asset bubbles."

Second, while it can plausibly be argued that no one really knows whether there is a bubble or not, this uncertainty by itself is not enough reason for central banks not to act. The real issue is whether an optimal monetary policy rule should depend on the degree of uncertainty. So "even if monetary authorities cannot separate with certainty the two components of an asset price -- the one based on fundamentals and the other not -- the optimal policy response implies reacting to the overall asset price (as opposed to reacting separately to its two fundamental and non-fundamental components)."

This is what the RBI is doing.

Posen, on the other hand, takes the diametrically opposite view. "Central banks should not be in the business of trying to prick asset price bubbles because the connection between monetary conditions and the rise of bubbles is rather tenuous." So if central banks get up to their usual tricks, like raising interest rates or reducing the amount available to the banks for lending, they will only cause a recession. "The cost-benefit analysis," says Posen, "hardly justifies such preemptive action."

It is important, he says, to appreciate that bubbles don't any longer create the sort havoc they used to. Good banking supervision ensures that. But there is a caveat: if the financial system is fragile, the central bank can land the economy in trouble by not acting in time.

Our financial system, by any reckoning, is fragile, which is why the RBI is intervening.

"In the end, there is no monetary substitute for financial stability, and no market substitute for monetary ease during severe credit crunch," says Posen. "These two realities imply that the central bank should not take asset prices directly into account in monetary policy making but should be anything but laissez-faire in responding to sharp movements in inflation and output even if asset price swings are their source."

In the end, as one can see, it all seems to boil down to the judgement of the managers, rather than the theories of the economists. If the central bank judges it right, no one notices, least of all the economists; if it gets it wrong, there is hell to pay, most of all from economists.

Peterson Institute for International Economics, Working Paper Series, Why Central Banks Should Not Burst Bubbles, January 2006.