Bleg: Grimes on bubbles

Arthur Grimes recently gave an interview to Reuters, all I’ve seen so far is this write up via Raf on Twitter (cheers).  Now Grimes is an incredibly good New Zealand economist, to put things in perspective I would generally put more weight on a single line of his opinion of something than I would on my own intuition and analysis of issues – an given that as individuals we are strongly biased towards our own views that is pretty significant.

But anyone who reads TVHE knows what I’m like, I just really really want to know ‘why’ certain things are being said!  I emailed a few economists and some suggested I do a bleg asking, so why not!

In the Yahoo story there are a couple of segments I’m a touch confused on and I’d like it if someone could answer them for me 🙂 (Note:  Seamus from Offsetting offers some example answers at the bottom of this post)

Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central bank action to support the economy would soon cause asset prices to return to their previous levels.

On the face of it this is a type of moral hazard argument where we have “implicit insurance” of asset prices by the central bank, leading to excessive risk taking, and weakening market discipline to prevent “bubbles”.

But let us think a little further, if the central bank is ensuring stability in the price level in a way consistent with closing the output gap/keeping unemployment near some natural level I’m not sure I see the issue.  Don’t we need to answer the question of why the relative price of assets to goods and services remains elevated due to central bank action?

Furthermore, if an asset price collapses with economic activity and then rises back to its prior level with economic activity was there really a “bubble” – can we really even say the “bubble” popped.

I don’t know what his “model of bubbles” is.  But I also know Grimes is insanely smart, so I was wondering if you have any idea of what the mechanism in this is?  What are we calling a bubble here, the rate of return on assets being lower than we think is reasonable, or is it due to expectations that are out of line with reality?  And where is the economic cost of this – if the volatility in asset prices merely causes a transfer between participants who cares.  After all we can’t just draw a straight line from asset prices to economic activity without asking “why” about the bubble – the ‘tech bubble’ and the ‘housing bubble’ were quite different beasts for example.

We may use some type of structural insurance argument.  My guess is that view in the above quote may involve implicit commitment by the Fed holding up asset prices relative to their fundamental value, therefore leading to excessive investment and greater borrowing for a given level of goods price growth.  But here the “asset prices back to their previous level” call makes no sense to me – as this implies that the relative price of assets is also returning.

Either this is an inconsistency, or I’m not sure if I buy this model of bubbles … as implicit insurance IS one of the drivers of fundamental value.  I really need a “model of bubbles” before this makes sense to me and I just don’t know what it is.  Furthermore, this is increasingly sounding like a structural issue rather than a monetary policy issue – as there is nothing inherent in stabilising the price level and closing the output gap that would imply asset prices will be ‘propped up’.

Note:  The model of bubbles matters.  We need it to understand policy.  And as Shiller, Sumner, and Gali have all noted this is a very difficult issue that doesn’t fit into a single box named “bubble”.

And then in terms of the conclusion.

“They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: ‘We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.'”

Stability in asset prices?  How does saying you will keep asset prices stable reduce the moral hazard issue – doesn’t it increase it by directly taking on systemic risk in asset prices.

Is this really something we should announce with regards to monetary policy?  How do we judge “stability” in this way, given that movements in asset prices as an aggregate are a useful piece of information about monetary policy (given their flexibility, and the fact that are made up of forward looking expectations about nominal returns).

Note that asset prices that are “too high” are an indicator that monetary conditions are “too loose”.  Is the complaint that monetary policy in the US tends to be too loose here?

And lets not even get started on trying to measure aggregate asset prices through time … that is an even stickier issue than measuring goods price 😉

What’s the bleg

I was just wondering what is being said in this article, and why.  What is the bubble mechanism being used?  What is the implied criticism of Fed policy?  In what ways does this imply that Fed policy should change?

On the face of it, I just don’t see the argument against simply targeting goods prices and closing the output gap (or NGDP targeting if you are that way inclined) in this piece.  And given the Fed has been easing policy INSUFFICIENTLY on this basis, the argument that their policy has been too loose also wouldn’t make sense.

Seamus Hogan’s answer

After I finished this post, but before I popped it up, Seamus from Offsetting Behaviour flicked me the following answer, and said I was allowed to pop it up here.  It offers a good framework for us to think of working through this question.  This was just a quick answer as him and Eric are a bit short on time to post a full discussion on it right now.  They were happy for me to pop it up here though!

My first pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. But at the same time that policy mitigates the extent to which the asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, why are we worried about the bubble in the first place?

My second pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. This policy will only partially undo the damage to the economy, but will heavily mitigate the extent to which asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, the inability to commit to not slightly help the economy in the event of a damaging asset-price-bubble burst will heavily increase the risk of such a damaging burst happening, and so the expected cost of future bubble bursts will be higher than in the case where the Bank could commit to letting the economy languish in a recession.

The two differences in these logic steps are in red. The key is whether the change in Point 4 makes empirical sense. If so, there is still an empirical question as to whether the relative magnitudes make point 6 in the second pass make sense, but the blogging point needs to rest on point 4. I’m not sure I buy it. I can buy that the Fed’s only help-the-economy-strategy—printing money (QE) or lowering interest rates can easily lead to leveraged portfolio investment rather than fixed investment, for some settings of expectations; I am having a hard time seeing how, though an asset bubble burst that largely goes away because of Bank policy can harm the economy.