Friday, 23 May 2008

Trichet on asset price bubbles

Jean-Claude Trichet made a speech in 2005 on Asset Price Bubbles and Monetary Policy. The full text is here. A few points leap out at me. Firstly Trichet raises the question as to whether there is such a thing as an asset price bubble:
I believe the NASDAQ valuation of the late 1990s was not excessive... [I] tend to believe that occasionally we observe behavioural patterns in financial markets, which can even be perfectly compatible with rationality from an individual investor’s perspective, but nevertheless lead to possibly large and increasing deviations of asset prices from their fundamental values, until the fragile edifice crumbles.
`Excessive' is a difficult word and I can see why Trichet is cautious about using it. But certainly the fair value of debt securities is the result of many phenomena including funding premiums and liquidity premiums as well as long term default rates. Their spread can tighten leading to asset price growth if funding is cheap and liquidity is plentiful without this necessarily being irrational.

The problem knowing how much is too much means that Trichet is cautious about the possibility of identifying an asset price bubble:
I would argue that, yes, bubbles do exist, but that it is very hard to identify them with certainty and almost impossible to reach a consensus about whether a particular asset price boom period should be considered a bubble or not.
He suggests one definition of a bubble:
[There is] a warning signal when both the credit-to-income ratio and real aggregate asset prices simultaneously deviate from their trends by 4 percentage points and 40% respectively.
I agree, but I would have thought that liquidity and/or funding premiums and the availability of credit would also provide helpful warning signals. As Trichet says:
A bubble is more likely to develop when investors can leverage their positions by investing borrowed funds.
Interestingly (for 2005) Trichet points out the positive feedback in a bubble pricking of collateral:
A negative shock is likely to have a larger effect than a positive one. The reasons are that credit constraints can depend on the value of collateral and that in case of a financial crisis the whole financial intermediation process can in the worst case completely fail.
After those insights the conclusions are depressing:
With regard to the optimal monetary policy response to asset price bubbles, I would argue that its informational requirements and its possible – and difficult to assess – side-effects are in reality very onerous. Empirical evidence confirms the link between money and credit developments and asset price booms. Thus, a comprehensive monetary analysis will detect those risks to medium and long-run price stability...

I fully advocate the transparency of a central bank’s assessment of risks to financial stability and of its strategic thinking on asset price bubbles and monetary policy. The fact that our monetary analysis uses a comprehensive assessment of the liquidity situation that may, under certain circumstances, provide early information on developing financial instability is an important element in this endeavour.
In other words we will try to tell you when a bubble is inflating but, beyond targeting inflation, there is little we are going to do about it. And M. Trichet did indeed keep to the second part of that promise.

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