Tackling asset bubbles

There is a sense that we have to do something about asset bubbles in order to prevent major financial disruption although it's not clear what is to be done and at what point. Frederic Mishkin, writing in the FT, draws a distinction between "credit bubbles", which are driven by excess bank lending, and "irrational exuberance", such as the boom in IT stocks in 2001. The former are a problem, he says, because they endanger banks. The latter are ok, some investors get burnt, that's all.

Right now, Mishkin argues, the US does not face a credit bubble although various asset prices may have shot up. Credit is, in fact, in short supply, so monetary tightening would be premature.

I am not entirely persuaded about this distinction. Take a stock market bubble. It could be driven, not by excess domestic credit growth, but by a surge in foreign inflows. Does this need to be tackled or not? A sudden withdrawal of foreign funds could cause the stock market to collapse and it may derail investment plans of companies to which banks are exposed. Domestic bank credit has not driven the stock bubble, yet banks could be imperilled.

Of course, the central danger to guard against is bank exposure to risk assets- real estate, stocks and commodities. But, it's not necessary that banks are at risk only from bubbles caused by excess credit. There could be an indirect impact on banks from the collapse of bubbles for which banks are not primarily responsible. Corporates' overseas borrowings, which find their way into the domestic market, for example.

Some bubbles may be more dangerous than others, as Mishkin points out, but all bubbles may need watching.