Bubbles and Central Banks: Historical Perspectives1 Markus K. Brunnermeier Princeton University Isabel Schnabel Johannes Gutenberg University Mainz, MPI Bonn, and CEPR 25 May 2014 Abstract: This paper categorizes and classifies some of the most prominent asset price bubbles from the past 400 years and documents how central banks (or other institutions) reacted to those bubbles. We first describe the different types of bubbles, the economic environment in which they emerged, as well as the severity of ensuing crises. We then derive a number of hypotheses regarding policy responses, broadly distinguishing between cleaning, leaning, and macroprudential policies. These hypotheses are then evaluated by providing illustrative supporting or contradicting evidence from individual bubble episodes. The historical evidence suggests that the emergence of bubbles is often preceded or accompanied by an expansionary monetary policy, lending booms, capital inflows, and financial innovation or deregulation. Bubbles preceded by a lending boom are typically followed by banking crises and severe recessions. The severity is less linked to the type of bubble assets than to the way of financing (debt vs. equity). Crises are most severe when they are accompanied by a lending boom, high leverage of market players, and when financial institutions themselves are participating in the buying frenzy. Regarding policy responses, we find that “cleaning up the mess” policies tend to be costly. “Leaning against the wind” through interest rate policies or macroprudential tools, such as 1 We thank Stephanie Titzck and especially Sarah Heller and Simon Rother for excellent research assistance. We are also grateful for the comments we received by the participants of the pre‐conference to this conference in Geneva. 1 the introduction of loan‐to‐value ratios, specific reserve requirements, or the restriction of lending in specific market segments, help to mitigate crises in some instances. However, the timing of the interventions is of the essence. Frequently, such measures are ineffective because they come too late or are too weak. Sometimes they are so strong that they lead to a bursting of the bubble. In such cases, “pricking” may still be better than having to face an even larger bubble later on but early intervention might have been even less harmful. The evidence suggests that macroprudential instruments can be a useful alternative to interest rate tools and may help to dampen bubble developments. However, they can also be ineffective if they are circumvented by an expansion of unregulated activities. The historical evidence has some resonance for today, and we derive a number of policy implications. 2 I. Introduction There is a long‐standing debate regarding the role that monetary policy should play in preventing asset price bubbles. In the years before the recent financial crisis, the Federal Reserve System and most other central banks were reluctant to use monetary policy instruments in order to tackle asset price bubbles. However, in light of the huge costs of the crisis many observers speculate whether these costs could have been avoided or at least reduced by a central bank taking into account the evolution of asset prices in its monetary policy. The debate gathered momentum in the aftermath of the crisis as it is feared that historically low interest rates and non‐conventional monetary measures may give rise to new asset price bubbles and thereby plant the seed for a new crisis. There exist a number of different views concerning the role of monetary policy with regard to asset price bubbles. Bernanke and Gertler (1999, 2001) argue that asset prices should play a role in monetary policy only insofar, as they affect inflation expectations. In this regard, the components of price indices used by policy makers play a decisive role. Typically, asset prices are not explicitly included in these price indices. However, real estate prices are indirectly taken into account through rents. Consequently, Goodhart (2001) argues that the whole debate could be solved if asset prices were given a larger weight in the inflation target. In contrast, others take the view that asset price developments should not be targeted by monetary policy at all. For example, the Fed’s declared policy prior to the subprime crisis was to “clean up the mess,” i.e., to mitigate the consequences of bursting bubbles rather than trying to detect and prevent asset price bubbles when they emerge (Greenspan 1999, 2002). Several arguments have been brought forward to indicate why monetary policy should not react to asset price bubbles. First, bubbles cannot be identified with confidence. 3 A deviation from the fundamental value of an asset could only be detected if the asset’s fundamental value was known. Second, monetary policy instruments are said to be too blunt to contain a bubble in a specific market. Therefore, other parts of the economy may be harmed by a proactive monetary policy. Third, bubbles appear to be a problem especially in combination with unstable financial institutions or markets. Therefore, bubbles should be tackled by financial regulation rather than monetary policy. This view has been forcefully opposed by the Bank for International Settlements (BIS). Several prominent BIS economists have argued that monetary policy should “lean against the wind,” i. e. try to prevent the build‐up of bubbles by reacting early on to upward‐ trending asset prices (Cecchetti et al. 2000, Borio and Lowe 2002, White 2006). Albeit recognizing the difficulties associated with the identification of bubbles, proponents of this policy approach argue that a passive role is not optimal. As in other decision problems under uncertainty, policy makers should rely on a probabilistic approach. To underpin these arguments, some point to the fact that many observers detected the recent housing bubble in the United States well before it burst. Moreover, the expected costs of bursting bubbles are said to outweigh the costs of early intervention. Such costs include, for example, the risk of new bubbles after following a cleaning approach. The reason is that such a policy is asymmetric, which tends to raise the price level and risks creating the next bubble. Finally, proponents bring forward that financial regulation as a means to avoid or counter asset price bubbles may not be fully effective in all circumstances. This regards the timing as well as the scope of interventions. With respect to timing, financial regulation may prove to be pro‐ rather than countercyclical. Concerning the scope, regulation may be undermined by regulatory arbitrage. Monetary policy may be a more effective tool, since it also reaches the shadow banking system. 4 In the run‐up to the recent financial crisis, the Fed and other central banks largely followed the Greenspan view of a monetary policy that did not try to prevent the emergence of bubbles. Instead, they “cleaned up the mess” when the crisis broke, for example through unconventional monetary policy measures. However, the recent crisis has shown quite plainly the huge costs that may arise from bursting asset price bubbles. This experience tilted the view towards more intervention, and the old consensus (Greenspan view) seems to shift to a new consensus closer to the BIS view (see, for example, the speech by Jeremy Stein, 7 February 2013; 21 March 2014). This paper attempts to shed new light on this debate by taking a historical perspective. We document the most prominent asset price bubbles from the past 400 years, characterizing the types of assets involved, holders of assets, policy environments during their emergence, severity of crises, as well as policy responses. Hence, our analysis can be seen as an informal meta analysis. The goal is to identify typical characteristics of bubbles, but to also show their great heterogeneity. We also try to link the severity of crises to certain characteristics of bubbles and to the respective policy responses. Interestingly, some historically employed policies can be described as early versions of macroprudential tools. Our overview of bubbles is inevitably selective. In particular, we typically learn about bubbles that either were not tackled and burst, or that were tackled by mistake, and that resulted in severe crises. In order to deal with this selection problem, we also searched for bubbles that did not result in severe crises because these are most likely to be instructive regarding effective ex‐ante policy measures. Although we cannot hope to remove the selection from historical reporting, this may help mitigating it. 5 The paper will proceed in Section II by describing our selection of crises and by providing an overview of the 23 identified bubble episodes, regarding the types of assets and economic environments. Section III tries to link the severity of crises to the described characteristics of bubble episodes. Section IV then develops a number of hypotheses regarding the effectiveness of various policy responses. These hypotheses are then tested informally by providing illustrative supporting or contradicting evidence from individual bubbles episodes. Section V concludes by summarizing our results and deriving some policy implications. The Appendix contains a detailed overview of the 23 crises on which our analysis is based. II. An Overview of Bubble Episodes II.1 Selection of bubble episodes Our analysis focuses on 23 famous bubble episodes from economic history. In order to identify these episodes we started from the full sample of crises in the seminal book by Kindleberger “Panics, Manias, and Crashes.” We reduced the sample by only considering episodes that were related to an asset price boom. Hence, an overheated economy would not be described as a bubble if no particular bubble asset was involved. For example, the Panic of 1819, which is sometimes called America’s first great economic crisis, can be traced back to an overheated economy including overtrading and speculation in nearly all kinds of assets. Other crises, such as the Panic of 1907, evolved mainly due to other factors, such as an unsound banking sector.