Asset Bubbles and Policy Response: A Historical View

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The economic growth and steady expansion of GDP and employment followed by a quick collapse could be best explained by the economic study of the United States (US) and Japan. In the US, before 1995 the net worth was about 3.5 times GDP. Between 1995 and 2009, the economy faced two periods of significant growth followed by quick flops. Trillions of dollars in net worth was gained and lost in each of the episodes. This was simulated by the performance of stock and real estate prices. For instance, the Dow Jones index peaked at the beginning of 2000 gradually fell and by the end of 2002, the index had lost more than 43% of its value. This was mirrored by the Case-Shiller index of real estate prices where increases by almost 60% and substantial falls were recorded around the same period. For Japan, by the late 1989, the net worth had increased from 4 times GDP to 6 times GDP.

This was followed by a rapid fall in the subsequent years. In the 80s, the Tokyo price index doubled up while the value of all the land in japan tripled up and by 1993, the boom in stock prices was undone and land prices nearly halved. These episodes are commonly referred to as bubbles. Policy makers were met out of guard with the great inflation; they based all their economic ideas on economic theories such as the Keynesian theory which were becoming obscene. There was need for innovative thinking and ideology (Martin & Jaume 18).

These examples suggest the importance of the interaction between asset-price bubbles and monetary policies for policy makers. The policy makers should be able to forestall and reduce the fallout from such collapses. In the 1990s and the early years of the 21st century, the federal reserve policy makers opted to adopt the mop-up-after strategy-policy of letting the bubbles burst and then mopping up there after. This strategy neither prevents bubble bursts nor reduces the price collapses associate with bubbles. Despite the loss of trillions of dollars, the strategy was a success in 2000 with the tech bubble. This strategy has however been subject to constant attacks based on the following points. It failed in the recent years, specifically with the subprime bubble which resulted to the destruction of the financial system. It is inherently inflationary; it allows bubbles to inflate the economy. It also forms a basis for the growth of more bubbles.

For example, the stock market bubble leading to the housing bubble. Generally, there are two types of bubbles: bank-centered bubbles and asset bubbles. The housing mortgage bubble is an example of the bank-centered bubble while the tech-stock bubble is an example of the asset bubbles. In controlling the bubbles, the Federal Reserve may fail to recognize bubbles until it is too late or get bubbles where there are none. For instance, the tech bubble was only recognized in 1999, by then it was huge. The Federal Reserve was blamed for housing boom that resulted to the housing market crash which lasted from 1998 to 2006. The belief is that the Central Banks influence on low short term interest rates, averaging between 5 and 6 percent, contributed to the housing boom (Roubini 34).

Crisis management can be defined as the manner in which an organization handles with certain threats in the organization. It involves crisis prevention, crisis response and planning. In the process of preventing crises, assessing crisis vulnerability is crucial in the strategic decision making process. Worst case scenarios should be identified, this would facilitate effective strategic decision making and also help prevent crises from occurring. This is one of the major challenges facing policy makers. In a financial long term strategy a SWOT analysis listing the strengths, threats and weakness of the economy is required as an instrument in planning. Policy makers are constantly involved in data collection; they gather important information with respect to a certain field and use such information in making strategic decisions (Lester 113).

Paul Volker an American economist was the chairman of the Federal Reserve from 1979 to 1987. He was credited with ending the stagflation crisis and high inflation rates in the US under President Jimmy Carter. As a result of high interest rates, especially on the farmers and constructors, the Volcker years were marked with the highest levels of widespread protests and political spasms. He helped calm one of the highest inflation in Americas history, in 1979 inflation was running over 13% a year, financial markets were afraid of renewed inflation and the value of the U.S dollar was falling. On his appointment by President Jimmy Carter in 1979, he controlled the exploding inflation and was popular with the financial community. Under his leadership, the Federal Reserve reigned in double digit inflation by setting money supply growth objectives.

This resulted to a substantial increase in interest rates peaking at 21.5% in 1980. This led to the worst recession in almost forty years causing unemployment to escalate to 10.7% in 1982, hiking of oil prices. This economic crisis forced the Federal Reserve to abandon the strict money supply targets. Surrounded with critics from investors and financial analysts, the congress reviewed the independence of the Federal Reserve. Nevertheless, Volcker served under three presidents, President Jimmy carter, President Ronald Reagan and President Barrack Obama. Volcker turned from a villain to a hero when in the mid-1980s he tamed inflation rates and improved the economy. Volcker Proposed the Volcker rule which restricts banks from making investments, such as hedge funds, that is not in good faith of their customers. What was learned from Volcker years is that: we should improve our economic models and prevent policy mistakes branching from bad economic advice.

The Federal Reserve should be effective, confident and should gain fortitude; it was not until Volcker that the Federal Reserve showed determination, that they could take the heat. It was also learned that until price stability is achieved, sustainable employment cannot be contained; inflation does not increase employment in the long term. The markets learned to come forward and speak up, everyone in the Federal Reserve System should be vigilant and allow the public to participate. Strong leadership is also required; Paul Volcker was a strong leader who remained resolute on matters of inflation despite attacks by protestors (Treaster 87).

Conclusion

In conclusion, the mop-up-after strategy still looks effective on bubbles not based on bank lending. On the other hand, bubbles centered on bank lending should be approached with care. If we have learned something, it is that raising interest rates to handle the bubble is not an effective strategy.

Works cited

Lester, Irving. Crucial decisions: leadership in policymaking and crisis management. Free Press, 1989. Print.

Martin, Alberto and Jaume Ventura. Economic Growth with Bubbles. Centre for Economic Policy Research, 2010. Print.

Roubini, N. Why Central Banks Should Burst Bubbles. Roubini Global Economics, 2005. Print.

Treaster, Joseph. Paul Volcker: The Making of a Financial Legend. Hoboken, New Jersey: John Wiley & Sons, 2011. Print.

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Asset Bubbles and Policy Response: A Historical View

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