Asset Price Bubbles and Monetary Policy- Robin Trehan

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Asset Price Bubbles and Monetary Policy- Robin Trehan

Is it possible to create a monetary policy that successfully
eliminates asset price bubbles? Some experts feel that this idea is “all hat
and no cattle”. It sounds good but is unlikely to work in the real world. Even
if it were feasible, it would weaken the free-market system.

Asset price bubbles – or “boom and bust” cycles, as they are
sometimes known – can be hard to anticipate or identify early on. It would be
extremely difficult to recognize a bubble before it occurred and take
appropriate action quickly enough to head it off. It would be a case of
“closing the barn door after the horse has run away”.

Some argue that there are various types of data, such as
price-return ratios, that could possibly provide the needed information in
time. But these indicators are by no means reliable proof of overvaluation.
There are just too many variables involved and the margin for error is simply
too big.

This is not the only drawback of attempting to avert asset price
bubbles using monetary policy. Even if such bubbles could be adequately
identified in time, raising interest rates or taking other actions to try and
head them off would be a case of “using an elephant gun to kill a mouse”. The
bubble would typically, although not always, be confined to a specific sector.
For example, in the late 1990’s tech stocks experienced a bubble.

It is impossible to execute monetary policy in a vacuum.
Clearly, any action taken to thwart a bubble in a certain sector is going to
impact the economy as a whole. Such an impact could easily throw off the
natural balance of the markets and even result in a depression.

Monetary policy can be a good tool for dealing with asset price
bubbles, but not for preventing them completely. Occasional asset price bubbles
are a natural features of a free-market economy. Monetary policy should focus
on keeping the economy healthy so as to minimize their negative effects and
reduce their occurrence. Unnatural interference with the markets is not the
answer. The right approach is “playing to the strengths” of both monetary
policy and the natural market function.

Robin Trehan is patner at private equity fund in Chicago
and  LA. More information about him can
be found on www.creditcapitalfunding.com  & www.businesscreditfunding.com