William C. Dudley, President of the Federal Reserve Bank of New York, recently offered some advice on the subject of formation of asset bubbles in the economy and what central banks can do to deal with it. The recent financial crisis highlighted how poor regulation made the financial system vulnerable and led to bubble formation.
Economic bubbles are created when assets, be it stocks, real estate, gold, oil, or anything else, are traded at inflated values. During his speech to the Economic Club in New York, Dudley admitted that identifying bubbles was a tough task as each bubble was unique.
The challenge that central bankers had to face in combating asset price bubbles arose because of the difficulty in identifying a bubble before it became too serious. He however clarified that these challenges should not be an excuse for inaction, given the huge economic cost that the country has to pay when these bubbles burst.
Policymakers need to identify imbalances in valuation that indicate an abnormal change in supply or demand, in other words, signs that a bubble could be forming. Dudley emphasized on the need to develop innovative tools to achieve this so that the formation of a new bubble can be understood well in time. This would allow regulators to take targeted action to stop a bubble from inflating further.
Dudley provided several possible solutions to deal with bubble formation, including:
Informing people about the dangers associated with an asset bubble, clearly explaining the risks to their money if the bubble were to burst. For example, if people knew that the house they were buying could fall by as much as 30% in value, they’ll be much more circumspect in making the purchase. This would help in checking unreasonable demand for the asset.
Change in policy and extending regulations and supervision of market participants in an industry that is at risk. For the housing market bubble, this would have meant scrutiny of lending practices of mortgage companies.
Using monetary policy to check money supply so that irrational consumer behavior can be curbed.
Dudley concluded by saying that a proactive approach was the best option for central banks to deal with bubbles. Waiting for a problem to become serious before reacting to it could result in a devastating price crash, like the one that caused the recent recession.