To Prevent Bubbles, Don’t Create Them

In their widely-cited Wall Street Journal column last week, Ian Bremmer and Nuriel Roubini argue that to prevent asset price bubbles in the future the Fed should focus on “properly calculating asset prices and the risk of asset bubbles according to the Taylor rule, an important guideline central banks use to set interest rates.” Central bankers such as Bill Dudley and Kevin Warsh of the Fed and Mark Carney of the Bank of Canada also propose that asset prices be factored in to interest rate decision criteria such as the Taylor rule. Adding asset prices to the Taylor rule would be a big change because the Taylor does not now incorporate asset prices, and much research, including Ben Bernanke’s research ten years ago, shows it shouldn’t.

The rationale for the proposed change is that the sharp run up in housing prices, which lead to the financial crisis, was caused by interest rates being too low for too long. If central banks had taken account of housing price inflation they would have raised interest rates earlier—so the story goes. They would have stopped the bubble before it got so big, or burst it when the burst would not have caused so much damage.

I agree that the Fed held interest rates too low for too long, and I provided evidence of this at the summer 2007 Jackson Hole conference. But the problem was not that the Fed ignored the housing boom. The problem was that it caused it. Look at the nearby chart from The Economist. It shows the Taylor rule without any asset prices and the actual interest rate. Clearly interest rates were too low. By deviating from the rule and keeping interest rates too low, the Fed caused the acceleration in housing prices. If the Fed had simply conducted monetary policy as it had in the 1980s and 1990s, we would likely not have had the housing boom.

Even putting aside the problems of identifing asset bubbles, pointed out by Donald Luskin, or the danger of creating collateral damage by doing so, adding asset prices to the equation would not address the real problem. Saying that adding asset prices to the central bank’s rule would prevent bubbles is like saying that requiring hikers in the forest to carry cell phones to call the fire department will prevent the damage from forest fires they start. By the time they call and the fire trucks arrive, the heat and flames will have caused tremendous damage. Far better to prevent hikers from starting fires in the first place. Far better for central bankers not to create bubbles in the first place.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Visit: John Taylor's Page, Blog

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