Financial bubble

Financial bubbles have a long tradition in academic literature. Early references to "bubbles" can be found in Keynes's (1936 [2007], pp. 158-9) General Theory, but the wide- spread use of this expression in the financial sphere has been popularized by the pioneer- ing contributions of Minsky (1975 [2008]) and Kindleberger (1978). Later, increasingly since the 1980s, a growing number of studies have attempted to analyse the dynamics leading to the emergence of financial bubbles, especially in the framework of general equilibrium analysis (see, in this regard, Tirole, 1985).

Conceptually, a financial bubble exists "if the reason that the price [of a financial asset] is high today is only because investors believe that the selling price will be high tomorrow - when 'fundamental' factors do not seem to justify such a price" (Stiglitz, 1990, p. 13, emphasis in the original). To put it in a nutshell, a financial bubble implies that the price of a financial asset deviates in a significant and persistent way from its so- called fundamental value (which, according to conventional financial theory, represents the discounted sum of future forecasted dividends over an infinite time horizon) because investors buy an asset today with the expectation of selling it in the future at a higher price, thus realizing a capital gain.

From an analytical standpoint, a distinction is usually drawn between "rational" and "irrational" bubbles. As the expression suggests, the former are consistent with the rational expectations and efficient markets framework. Even if investors behave rationally - that is, taking all available information and fundamental factors into account - "rational" bubbles emerge owing to self-fulfilling expectations or some other market failures, such as incomplete markets or information asymmetries. On the other hand, "irrational" bubbles imply an irrational bias on the part of investors - a sort of "irrational exuber- ance", in the words of Greenspan (1996). Investors are thus misled into overstating an asset's expected discounted stream of dividends, thereby forming excessively optimistic expectations about its fundamentals. Phenomena such as herding behaviour or flawed perceptions of fundamental values may explain the emergence of "irrational" bubbles (see Coudert and Verhille, 2001, pp. 101-02, for analytical elaboration and references).

Now, regardless of the nature of a financial bubble, a time-honoured debate is centered on whether central banks, owing to the potentially high costs of a bursting financial bubble in terms of output losses and financial system instability, should seek actively to lean against an inflating bubble in the quest for preserving macroeconomic and financial stability over a more distant horizon than the conventional one-to-three-year horizon relevant for monetary policy. To be sure, the pre-crisis consensus on monetary policy was firmly anchored in the belief that central banks should follow a "benign neglect" policy as regards financial bubbles. On the one hand, central banks should not react to or prick what they may perceive as an incipient bubble, except in so far as its build-up has implications for the path of output and inflation over the medium run and, hence, risks jeopardizing the attainment of the ultimate goals of monetary policy, to wit, price stability and sustainable output growth. This belief is supported by the efficient market hypothesis, according to which markets always price financial assets at their fundamental value, thereby ruling out the existence of bubbles. Likewise, even if financial bubbles were assumed to exist, the main policy tool at the disposal of central banks - to wit, the short- run interest rate - is too blunt a tool to defuse an incipient bubble. As a matter of fact, nothing except a large increase in the key policy rate of interest is necessary to rein in an inflating bubble, which would depress economic activity considerably. Finally, especially when investors' expected returns are abnormally high, even a sizeable tightening of the monetary policy stance may not prevent a bubble from inflating further. On the other hand, as soon as the bubble bursts, central banks must "clean up the mess" and take whatever measures are necessary to mitigate the economic fallout and avoid the potential disinflationary pressures unleashed by a bursting bubble. All in all, the "benign neglect" approach is highly asymmetric as regards the treatment of suspected financial bubbles. This creates a potential moral hazard problem among market participants (commonly referred to as the "Greenspan put") that sows the seeds for potentially even larger bubbles in the future.

Now, the 2008-09 global financial crisis, which was triggered by the bursting of a major financial bubble in the US real estate market, has challenged the conventional wisdom and swung the ideological climate with respect to financial bubbles back in favour of a more pragmatic approach. A growing number of economists and central bankers (see, among others, Kohn, 2008) have partially recanted their ideological positions and acknowledged that addressing an inflating bubble early enough through a "leaning against the wind" (LATW) policy may, in some cases, yield potential benefits. This not- withstanding, financial bubbles remain hardly identifiable on a real-time basis or at an early stage of development, thus complicating the implementation of a timely calibrated monetary policy response. Further, the ideological and institutional framework govern- ing inflation-targeting regimes constitutes, to date, an obstacle for the implementation of an effective LATW policy. Indeed, especially if a bubble emerges against the backcloth of strong economic activity and subdued inflationary pressures, any tightening of the mon- etary policy stance in order to enhance macroeconomic and financial stability in a more distant future will hardly be explainable and justifiable to market participants and will likely face huge political opposition. To overcome these difficulties, other more targeted tools are currently being considered in the area of macroprudential policy to lean against incipient financial bubbles, especially if these are accompanied by other imbalances, such as excessive credit growth.

See also:

Asset price inflation; Bubble; Efficient markets theory; Financial crisis; Financial insta- bility; Greenspan, Alan; Housing bubble; Inflation targeting; Macro-prudential policies; Minsky, Hyman Philip.