Central bankers recognise a ‘bubble’

For years, former US Fed Chairman Alan Greenspan said that it was impossible to recognise an ‘asset bubble’ until after it had burst. Thus the dot-com bubble, and the US housing bubble, were able to grow without central bank interference.

Now however, Fed Governor Frederic Mishkin has broken ranks and provided this detailed description of how a ‘bubble’ develops:
• “Financial history reveals the following typical chain of events: Because of either exuberant expectations about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets and thereby raising their prices. The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence their prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease as lenders become less concerned about the ability of the borrowers to repay loans and instead rely on further appreciation of the asset to shield themselves from losses.
• At some point, however, the bubble bursts. The collapse in asset prices then leads to a reversal of the feedback loop in which loans go sour, lenders cut back on credit supply, the demand for the assets declines further, and prices drop even more. The resulting loan losses and declines in asset prices erode the balance sheets at financial institutions, further diminishing credit and investment across a broad range of assets. The decline in lending depresses business and household spending, which weakens economic activity and increases macroeconomic risk in credit markets. In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.”

The consequence of allowing ‘bubbles’ to grow is that one then has to take extraordinary steps to try and protect the ‘real economy’. This is the Fed’s rationale for its dramatic interest rate cuts over the past few months. But its cuts have also caused inflation to rise – providing a major headache for other central bankers.

In turn, this has led the Bank of England’s Governor, Mervyn King, to reveal his frustration with the consequences of the Fed’s actions. Faced with having to write a public letter explaining why inflation is above the official target, he speculated on Thursday that ‘I think we might point out in that letter that we did not fall prey to the sirens who were pressing us to cut interest rates as rapidly as some other central banks have done’.

In the discreet world of central banking, that is the nearest to a public rebuke of a fellow bank’s policy that one is ever likely to see.

About Paul Hodges

Paul Hodges is Chairman of International eChem, trusted commercial advisers to the global chemical industry. The aim of this blog is to share ideas about the influences that may shape the chemical industry over the next 12 – 18 months. It will try to look behind today’s headlines, to understand what may happen next in important issues such oil prices, economic growth and the environment. We may also have some fun, investigating a few of the more offbeat events that take place from time to time. Please do join me and share your thoughts. Between us, we will hopefully develop useful insights into the key factors that will drive the industry's future performance.

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