Why Asset Bubbles Should Not Be Popped

In the past, many financial bubble bursts had negative consequences on the real economy in many countries. Recent examples are the burst of the bubble in Japan in 1991 leading to the “Lost Decade” and the burst of the U.S. real estate bubble in 2006 resulting in the Global Financial Crisis. The question is: “can something be done about bubbles in order to minimize losses from bursting?"

Typically, bubbles arise in economies where liquidity is abundant. Central banks, in turn, have instruments such as money supply and interest rates to adjust the liquidity. Consequentially, it can be argued that central banks can react to asset bubbles and can try to destroy them by fine-tuning the monetary policy. Many analytic models provide evidence that this approach can be successful (Roubini, 2006). However, whether central banks should have the obligation to respond to financial bubbles stays highly controversial in academic literature because costs of reacting to bubbles may in many cases exceed the benefits. 

There are difficulties associated with central banks’ interventions in bubble economy. Recognition and forecasting of bubbles is a very complex task because decisions have to be made based on indirectly observable parameters. Given the uncertainty of information (Bernanke, 2002) central banks may adjust the monetary policy incorrectly so that it may cause harm to the economy rather than protecting it implying that central bank interventions involve high risks. Monetary policy itself may also be a too weak instrument (Posen, 2003) for bursting bubbles. Bubbles are believed to be caused for the most part by irrational behaviour of investors and not by changing fundamentals such as interest rates or credit availability. Thus adjusting interest rates and money supply will not necessarily stop a bubble’s growth. In addition, it must be said that not all bubble bursts cause losses in real terms to economy, only economies with undeveloped, fragile banking systems are subject to serious harm when a bubble bursts. Mishkin and White (2002) analysed 15 US stock crashes and found that only about half of crashes led to strong negative effects.

It is obvious that some bubbles can lead to serious harm for the real economy. However, the research shows that proactive intervention in the economy by central banks is a very risky business without guarantee of positive outcome. Therefore central banks should only react to bubbles when the potential losses of foregoing the action are tremendous.