Will a more expansionary monetary policy give rise to a bubble?

I’ve been seeing a lot of this question in my Twitter feed.  Here are a few points:

1. If a more expansionary monetary policy helps an economy recover, yes it may well raise the risk of a later bubble.  We should then be cautious, but that is no reason to turn down the prospect of a recovery.  Anything leading to recovery could have a similar risk.

2. There are already plenty of reserves in the system and there is plenty of room for credit to expand over its current level.  Maybe we don’t know what triggers bubble-inducing investment behavior, but why should raising ngdp expectations and realities raise the risk of a bubble, if not for the factor cited in #1?

3. Arguably a flat yield curve induces a quest for higher returns elsewhere or in more dubious investment areas.  Yet the flattening yield curve did not follow quickly from the massive injection of reserves.  Rather it evolved slowly as prospects for real recovery deteriorated and the long-run outlook for the advanced economies turned down.  Real factors drove the flattening, and if monetary expansion brought a bit of recovery it likely would unflatten that curve a bit.  That could well lower the risk of a bubble.

4. I may consider Austrian theory, with regard to this question, in a separate post.

Overall I don’t see this as a reason to reject monetary expansion.  #1 is a real risk but again I’ll take the recovery every time and a lot of the other arguments boil down to that trade-off.


Bubble, boom and recovery (sounds like a good book name) are distinct things. Recent bubbles have been (IMHO) due to the lack of real investments (bubbles are speculations in lieu of investment) resulting from TGS. There is no boom and no real recovery therefore there are bubbles of a particularly bad sort.

There's already a "The Boom and The Bubble."

Bubble in what? Real estate? Gold? Oil? Commodities other than corn and soybeans? Postage stamps? Old masters' paintings? My naive non-economist brain tells me that a bubble comes from money chasing goods whose intrinsic value is much less than the market value (thank you Charles Mackay who made this observation well over 100 years ago; maybe more marginalrevolution posters should read him rather than Ayn Rand). In this country at the present time the only ones who can create a bubble are the upper 2% who have the money and don't need to deleverage their debt. For them the concept of a bubble is essentially meaningless since they can absorb any losses that might occur (unless of course they spend money on fraudulent Madoff schemes which surprisingly does happen). For the unemployed, underemployed, and those just scraping buy (the vast majority of Americans unfortunately), the last thing they are worried about is a bubble in anything (with the lone exception of bubble gum which I'm especially partial to). With slack demand which is the underpinning of where we are economically I cannot see a bubble in the future and my garden catalog tells me that tulip prices are remarkably stable this year though I don't know much about Mississippi real estate.

Yes it's true we can't see the next bubble coming before it starts. Of course that was the case with all previous bubbles as well.

We are the 98%?

If the Fed kept NGDP growing steadily, and the leverage of financial institutions were held down Volker rulishly, I don't see why a bubble in some asset class is to be feared.

Bingo. 'Twas the leverage that wrecked us, not the bubble per se.

As I understand it, Canada is deep into a real estate bubble. It would be interesting for a young academic to do a study of Canadian home buyers to understand why, after what happened in the US, UK and Ireland, they are willing to pay peak bubble prices for homes.

It's different this time.

Don't worry, *I'm* going to sell before everyone else does.

I'm really starting to be bothered by the term "recovery." What people mean by "recovery" is a return to GDP growth rates consistent with the so-called "Great Moderation." The Great Moderation's growth rates are considered by critics of monetary expansion to be the very bubble that created the Great Stagnation.

Therefore, if we accept the term "recovery," we are just euphemising the term "bubble."

How about we just stop tinkering with the economy from the top down and let the market do what it does best; allocate resources accordingn to consumer preference?

It's even worse! If any aggregate activity peak level is good and "recovery" is only achieved by a resumption of the past peak, you have institutionalized boom creation.

If the US economy were move towards a return to "full employment" (argue amongst yourselves what that is) and if the Fed could move away from the zero-bound without triggering disinflation and/or deflation and economic contraction, I'd feel fine labeling that a "recovery" regardless of the GDP growth rate.

But out of curiosity, what number for GDP growth rate did you have in mind when you wrote that comment about the growth rates of the Great Moderation? 3%? Are you saying 3% is bubble-level growth?

It's hard to talk about aggregate growth rate expectations in light of bubbles, given that bubbles are sector-specific by definition.

This particular bubble was a unique one in that asset price bubbles impact loans and investment. Collateral value was over-stated, so to many folks it seemed that "everything was over-stated." Economic indicators like GDP are especially susceptible to this kind of illusion.

"It’s hard to talk about aggregate growth rate expectations in light of bubbles, given that bubbles are sector-specific by definition."

Given that you accept this indeed valid point, then how you argue that the growth rates of the Great Moderation are not worth returning to? During a recession, the total output of the economy falls, not just output in the "bubble" sector. Even if bubbles are a possible consequence of monetary expansion, I would still rather have a more productive economy than stagnating growth rates.

Maybe I'm misreading you, but this sounds like the old Krugman claim that we should create a housing bubble to help us recover from a dot-com bust.

I think returning to a natural rate of unemployment is what determines a recovery. Nobody is arguing we go back to 4% unemployment. But 6% unemployment and 60%+ employment-population ratio would be nice.

The Great Stagnation did not cause our current unemployment quagmire. That's policy failure.

Nope. I don't buy the Monday morning quarterbacking from either side. Unemployment woes are part of the fall-out from a fifty year party that had to end sometime. This was how it was gonna be. Less stimulus would not have meant an appreciably faster recovery, and more stimulus, i.e. one more trip to the punch bowl) would have kicked the can down the road to some future, uglier day of reckoning.

The good news is, at this point, Americans might be about as rich as they think they are.

Lower wages and wealth, absolutely. But high unemployment is not punishment for a bubble. It is policy failure.

If you suddenly found out you're poorer than you thought, the first thing you would do is get back to work. You would do anything to start generating some income. The problem is the labor market can't clear at current wages and with current policies.

"You would do anything to start generating some income."

One would think. Not sure that's the prevailing attitude.

So the policy prescription for high unemployment is allow employers and employees to bargain for the market-clearing price just like we do our groceries, our iPads, our firearms, our plastic surgeries, our cars, etc. Next question?

Of course, that would be downright Hayekian so instead we get this Rube-Goldberg-style thinking to "lower real wages" by money-printing. Then the economists remain perplexed by "sticky wages." So now they set their twitchy fingers to fiddling with the knobs on some other macro policy. Then something else pops up and they've got to run over and fiddle with that. And on and on.

Keynesianism is such a bizarrely bass-ackward way of looking at things. It's like watching some Daffy Duck-sperg-cartoon fantasy meltdown. ("And THITH ith where the money will go!...")

Speculative bubbles are quite rare. Some economists in the 80s and 90s argued they could not exist and used other theories to explain tulipmania, etc.
So it's probably a mistake to undertake or avoid an action because it might lead to a bubble, just as it would be a mistake to turn down work in Oklahoma because you're worried about tornadoes.

That's a good analogy.

Not totally inprobable. Bubbles are caused by too much supply-side 'investment' pushing money into speculative ideas, with too little demand-side pull of the funds through a market where information can be distributed by price signals . So using monetary policy is more likely to create asset price bubbles, especially at lower bound where a large part of monetary policy is achieved by changing financial asset prices.

"Bubbles are caused by too much supply-side ‘investment’ pushing money into speculative ideas..."

If so, then are such investments really a hindrance to sustained economic growth? Isn't it this speculation, which I prefer to think of as a healthy trial-and-error process, that often leads to spectacular innovations?

"I may consider Austrian theory, with regard to this question, in a separate post.

Tyler, make sure to explicitly red flag the fact that your "Austrian theory" isn't Hayek's theory, and that you haven't and aren't pretending to address the question of "expansionary monetary policy" in light of Hayek's work in monetary theory and macroeconomics.

Rather than focusing on reserves or indicators like excess liquidity (see below) which aren't finding their way into the real economy given banks' regualtory deleveraging and general cash-rich position of businesses, would focus instead on zero yield on cash and how that's driving various types of investors further up the curve (households from money markets into bonds, real money from G10 govies into EM local currency bonds and hedge funds into higher-yielding fx) or into riskier assets potentially leading to asset bubbles down the road (think asset inflation over goods inflation).


The big issue with "monetary policy causes bubbles" arguments is they miss that monetary policy can work through either increased investment or increased consumption.

For example, the typical argument for the Fed Funds Rate causing an increase in AD is through lower interest rates increasing loan demand and decreasing savings demand. That is part of it, but lower interest rates also increase demand through moving consumption forward. Savings are meant to be spent eventually and lower real interest rates moves consumption further into the present.

For bubbles to happen, it means that investment happens when that money should have either been put in a vault or should have been spent. That is a regulation and principal-agent problem issue, not a monetary policy issue.

"For bubbles to happen, it means that investment happens when that money should have either been put in a vault or should have been spent."

I disagree. It is possible to have demand-driven bubbles too, like the recent housing one, where increased demand for homes led to rising home prices. Our education sector is another example of this.

The housing bubble would not have been as severe if the Fed had pursued a tighter monetary policy. Same with education - the loans are relatively easy to get because the government subsidizes them.

Historically, bubbles are relatively rare.

OK, we just went through one, maybe two so everyone has bubbles on their mind and the financial press sees a bubble every time they turn around.

Given that we have just had two bubbles I would suspect the odds of having a third one would be rather remote.

I keep thinking the big difference between the US and Japan is they had their two bubbles concurrently while the US had its sequentially.

"Given that we have just had two bubbles I would suspect the odds of having a third one would be rather remote."

Gambler's fallacy?

What is Greenspan saying in this interview in BusinessWeek?
Q: Would you agree we’re in a liquidity trap now?
Greenspan: I can’t discuss that. I could, but I’m not.
Q: I mean there are limits to how far monetary policy can work in a case like this, right?
Greenspan: I’ll put it this way – Ben Bernanke has a far more difficult job than I had. He’s a very competent, experienced economist.
Q: Do you ever talk to him?
Greenspan: Of course. We are both fluent in Fedspeak.

An analogy: Keynesianism is to Austrianism or sound money economics as that choice given to Olympians once in a poll: "if you could take a performance enhancing drug today that will win you a gold medal now, but kill you in the long run, would you take this drug?" Apparently 50% of athletes said 'yes'. Keynes is dead and this is the long run now.

How do you get bubbles with the EMH? And if you think markets are inefficient, then why aren't you a Keynesian or Monetarist?

"I may consider Austrian theory, with regard to this question, in a separate post."

Cowen just separates the arguments so he can use whatever pieces of different theories to oppose policy he does not like based on affect heuristic. A little bit of inefficient markets here (Keynesianism). Maybe a little bit of hard money there (Austrian). Can't use Monetarism because they're pro-monetary policy.

And so you get Tyler Cowen: Economist of Whichever School is Most Advantageous at the Moment.

As a great once said (Walt Whitman): "Do I contradict myself? Very well then, I contradict myself". TC is larger than life. And economics lends itself to the three blind men describing the elephant: one at the trunk, another at the tail, a third at the legs. Econ is non-linear so you can and should pick what works best. I personally think that during Fordist times Keynesianism works, while during more atomized wheeler-dealer times laisse-faire / Austrian / gold standard works, and during normal times Monetarism works. Pick and choose, but as the Kung Fu movie says "choose wisely grasshopper".

Because the inefficiencies show up and get liquidated instead of government using monetary and fiscal policy to keep rich idiots and frauds from becoming poor.

I would be interested in what Real factors Dr. Cowen believes flattened the yeild curve. Not sure if he is counting the twist operation as a real factor?

I'm admitting that I have no real idea of what you mean with your continuous use of the word "bubble". Is that a "inflationary bubble" or a deflationary "bubble".? Is it a soap Bubble? Where does this word come from? Does it explode? Does it sit with other bubbles like bath bubbles? If you mean inflation maybe you should use the term Inflationary bubble or deflationary bubble. Perhaps it means an excess of dollars issued contained within a bubble of over issuance causing more expansion of natural resource currencies values. Perhaps you mean a "Bubble' of food prices that has increased since 2008 one hundred percent (100%) and more in retail costs; and fuel Close to100%. That's a bubble cleverly hidden by the Fed with the use of "Core CPI". By the way why do they call it "Consumer" price index when they relegate two of three primary requirements(Food, Fuel & Shelter) for life from a more pronounced effect. I know! The Fed is worried about our Bubble!

1. "Anything leading to recovery could have a similar risk."

That's where you're wrong. MONEY creates bubbles. Nothing else.

2. Don't fall into the Sumner trap of treating "NGDP expectations" as if they are a real thing.

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