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posted on 07 September 2015

Bubbles And Fools

from the Chicago Fed

In the wake of the financial crisis of 2007 - 08 and the Great Recession precipitated by it, a growing chorus has argued that policymakers ought to act more aggressively to rein in asset bubbles - that is, scenarios in which asset prices rise rapidly and then crash. Before the crisis, conventional wisdom among policymakers cautioned against acting on suspected bubbles.

As laid out in an influential paper by Bernanke and Gertler (1999), there are two reasons for this. First, while asset prices are increasing, it is difficult to gauge whether these prices are likely to remain high or revert. Second, many of the available tools for reining in asset prices, such as raising nominal short-term interest rates, tend to be blunt instruments that impact economic activity more broadly. Bernanke and Gertler argued that rather than responding to rising asset prices, policymakers should stand ready to address the consequences of a collapse in asset prices if and when it happens.

The severity of the Great Recession and the challenge of trying to stimulate economic activity even after lowering short-term rates to zero led many to rethink whether policymakers should wait and see if asset prices collapse and then deal with the aftermath. Of course, just because the stakes are great does not mean policymakers can or should do anything if they are concerned about a possible bubble. To determine whether anything can or should be done, we need to understand when and why bubbles can emerge and what that might mean for policy. This article considers one explanation for bubbles known as the greater-fool theory of bubbles, as well as its implications for policy.

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