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Asset Price Bubbles: Lessons From The Recent Financial Crisis

By Douglas Evanoff, George Kaufman & Anastasios G. Malliaris

The successful performance of the U.S. economy during the ‘Great Moderation’ period of 1984 to 2006 appeared to have offered both the economics profession and policymakers the assurance that asset bubbles could be effectively managed with little or no real adverse economic impact.  But the recent global financial crisis had a serious adverse impact on the U.S. and global economies, and has triggered a renewal of the debate about the impact of bubbles and the role of public policy in addressing them.   

In this article, we summarize the post-crisis state-of-knowledge on (1) conceptual issues concerning the existence of asset price bubbles, (2) the consequences of bursting such bubbles, (3) monetary policy ‘management’ of bubbles, and (4) the role of macroprudential regulation in addressing bubbles. We conclude with a list of lessons learned from the recent financial crisis and a call for additional evaluation of the characteristics of asset price bubbles.

Should asset bubbles be treated as benign events beyond the practical reach of policymakers? The successful performance of the U.S. economy from 1945 to 2006, and, in particular during the Great Moderation period of 1984 to 2006, including the two stock market crashes in 1987 and 2001, appeared to have offered both the economics profession and policymakers the assurance that asset bubbles could be effectively managed with little or no real adverse economic impact.  But, this perception changed following the recent global financial crisis.  This crisis has had a serious adverse impact on the U.S. and global economies, and has triggered a renewal of the debate about the impact of asset price bubbles and the role of public policy in addressing them.

Prior to the global financial crisis, the Federal Reserve under both Chairman Alan Greenspan and Chairman Ben Bernanke followed an asymmetric policy approach to asset price bubble management. In the absence of inflation in goods and services, this approach advocated no, or minimal, restrictive monetary policy action during the formation and growth of a bubble, but a speedy response to ease policy once the bubble burst to reduce the potential loss of output and employment.  This strategy was based on several factors:  ex ante difficulties in identifying bubbles; concerns about the effectiveness of monetary policy to manage asset bubbles; and the expectation that losses to the macroeconomy from bursting bubbles could be limited with quick, aggressive responses.

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