How destructive are asset price bubbles really?

The recent years have been filled with heated discussions on the nature of bubbles and their effects on the real economy. Bubbles, of course, are generally considered to be episodes during which the price of an asset rises above what would be justified by looking at the “fundamentals” that are supposed to give the asset its price. They have been forming and bursting at least since Tulip Mania back in 1637, yet our understanding of this phenomenon remains fairly dismal. What seems to be certain, however, is that the bursting of large bubbles can have disastrous effects on the real economy, as seen most clearly by 1929’s stock market crash that led to the great depression, Japan’s asset price bubble in 1989 that lead to two lost decades, and most recently the housing bust that started in 2006 and the impact of which we now feel in what has been dubbed the great recession. There is only one problem with that story. It is not really true.

In fact, the direct impact that bubbles bursting have seems to be remarkably small. The Great Depression was not caused by Black Friday, as is still commonly believed. Sure, it was a drastic event and one that had a deep psychological impact on the public, but nothing that would lead to a depression that would last up until the start of World War 2. Nor were the protectionist measures, the most visibly of which was the Smoot-Hawley Tariff Act passed in the United States, the main reason for it. Instead, it was as simple a case as central banks not doing their job (which, to be fair, might have been interpreted differently back then). Milton Friedman and Anna Schwartz pointed out back in 1963 that what made the Great Depression truly great was a massive contraction in the money supply between 1929 and 1933, a time when the Fed should have been considerably expanding it. No wonder Bernanke felt compelled to admit, on Milton Friedman’s ninetieth birthday, that “you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.” Turns out that was quite a bit of wishful thinking as well, but we do seem to have learned a lot since then.

The effects of Japans asset market crash are also vastly overstated. It was only the failure of policymakers in its aftermath, and in fact in the entire 20 years following it, that turned a bad situation into a catastrophe. As Adam Posen, former member of the Monetary Policy Committee of the BoE and currently president of the Peterson Institute for International Economics (no, despite the name not part of the other crazies that get funding from Pete Peterson), wrote back in 2003 (.pdf), “it is what happens after the bubble bursts that is truly important for macroeconomic outcomes“. That point cannot be emphasized enough. While the bubble bursting did cause a somewhat minor recession between 1991-94, it was Japanese tight monetary policy and fiscal austerity that halted the recovery in its tracks in 1995-96, and of which the country until recently did not manage to recover. Apparently it took Japanese authorities almost two decades to learn their lesson, and even though the whole thing has not played out, they have recently shown that it seems remarkably easy to break out of their self-created trap.

The Fed under Bernanke did not only acknowledge the disastrous role it played back in the 30s, it also indeed seems to have learned from the episode. It forcefully reacted after the effects of the bubble became apparent and crashed against the zero lower bound with the Fed funds rate, following which it started trying a bunch of approaches including its three quantitative easing programs in an attempt to gain traction when interest policy cedes to be an option. It must also be noted that this housing bubble, being credit-financed, by its very nature had more widespread effects on the real economy than a “normal” bubble not accompanied by the level of credit-expansion we experienced. Yet all this does not change the fact that NGDP tanked in 2008 and is still far below the level it should be if stable growth had continued. It is the central bank that should control NGDP growth, and even though there are very real difficulties involved in achieving this under the current circumstances, monetary policy in the US – not to speak of the Eurozone – remained too tight for too long (and arguably still remains so) given the state of the economy. Monetary (and possibly fiscal policy) have played and continue to play major roles in contributing to extended periods of economic stagnation. But it is not by disregarding asset prices on their way up that their biggest failings become apparent, but in their reaction to the effects of prices on their way down and what happens in the aftermath of a bubble bursting that they are most strongly felt.


2 thoughts on “How destructive are asset price bubbles really?

  1. Here in Ireland we have a massive asset bubble in property which burst. GDP fell by 14% in 2 years and unemployment is still at 14% 5 years later. So yes bubbles are damaging.

    Also Firedman’s interpretation of the Depression has been disputed. The contraction in the money supply was arguably a result rather than a cause of the Depression. However, the strongest evidence is the fact that Bernanke has massive increased the money supply through QE with minimal effects, suggesting that money supply is not the main cause of recessions.

  2. Thanks for the comment. You certainly know more about Ireland than I do, but I would argue that it is particularly Ireland that proves the point I tried to make. Sure, the bubble bursting had a massive effect, but the country also embraced the idea of expansionary austerity much more strongly than most others. It really shouldn’t have needed something like the Reinhart-Rogoff story to make clear that this is terrible policy making given the circumstances. The whole idea that Ireland, with probably the most flexible jobs market in Europe, suffers from mainly structural problems was absurd to begin with.

    Whether the contraction of the money supply is result or cause is fairly irrelevant to the argument – the main point is that it is central banks who control the money supply, and in a depression it should rise, not fall. Sure, the gold standard made that difficult at the time, but that doesn’t mean it was not a policy failure. This is a fascinating paper by Christina Romer, in case you’re interested:

    I would also disagree on your thoughts on the effects of QE and the role of the money supply, but the topic is a complicated one. offers an overview of research trying to assess the effects of recent unconventional monetary policy, and by and large the results seem argue that the effects are considerable. What transmission channel is at play in getting through to the real economy is a different topic – it is quite possible the direct effects are low with most of the work being done by changed expectations. Japan seems to prove this as well.

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