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Op-ed

Put the Puritans in Charge of the Punchbowl

by Arvind Subramanian, Peterson Institute for International Economics
and John Williamson, Peterson Institute for International Economics

Op-ed in the Financial Times
February 11, 2009

© Financial Times


The Greenspan "put"—the idea of Alan Greenspan, former US Federal Reserve chairman, that monetary and regulatory policy cannot prick asset price bubbles but should deal with the consequences when the bubble has burst—now looks dangerously quaint. Such "asymmetric" policy responses are out. But if they are to be replaced by more symmetric, countercyclical policies, then explicit or implicit target or guidance zones for the prices of all main assets—shares, housing, exchange rates, and perhaps even oil—are unavoidable.

The intellectual justification for the Greenspan put—articulated by Ben Bernanke, the current Fed chairman—was that identifying equilibrium levels of asset prices is difficult; and policy tools to prick or limit bubbles are limited. The unmentioned but perhaps real rationale is a kind of implicit market fundamentalism: Markets value assets best, and even if markets make mistakes, policymakers can never be sure in advance whether and to what extent mistakes have been made.

However, the wreck that is today's financial system is testimony to the catastrophically flawed nature of that doctrine. Policymakers have no choice but to have a view on what constitutes a reasonable or equilibrium level of all asset prices. Of course, determining such levels is subject to uncertainty. The most it is prudent to contemplate is that policymakers should determine not reasonable levels but reasonable zones for asset prices. One of us has in the past argued for exchange rates to have target zones with a margin of 10 percent around the central estimate. Perhaps that is too narrow, and perhaps it is unwise to specify hard target zones with an obligation to intervene to prevent rates moving outside them, but it is wrong to say there are no guides for where targets should be set.

In some cases, one must take account of rapid productivity growth or the discovery of oil. In other cases, real currency values remain pretty constant over the long run. If the rate of real dollars per real pound departs far from historical levels, one knows that it will revert. It is silly to pretend that we are totally ignorant. Otmar Emminger, former Bundesbank president, used to say that, while he could not identify an equilibrium exchange rate, he could certainly tell a disequilibrium rate. We are asking no more than that the authorities should think in advance about what disequilibrium rates for asset prices look like and seek to keep rates from straying into such realms.

The width of the zone should certainly vary depending on the asset and the associated uncertainty in determining equilibrium asset price levels. Note that history provides guides for assets other than exchange rates: When house-price/income ratios, or price/earnings ratios depart far from historical levels, they revert. One might accor­dingly think of a zone for house prices of, perhaps, plus or minus 30 percent; and for equities of, say, plus or minus 40 percent; and, more controversially, for oil of, say, $40–80 per barrel. Some might balk at trying to set floors for asset prices. But proposals in the current crisis, from government purchases of equity to lowering mortgage interest rates in order to prevent housing foreclosures, amount in effect to setting floors.

Even zones this wide would have called for action—on exchange rates, house prices, equities, and oil prices. A key question is obviously: What action?

The corrective action would depend on the nature of the bubble. It could be either national or international. For example, if the departure relates to the exchange rate, coordinated intervention might be warranted. In the case of oil, cooperation between the main oil exporters and importers might be necessary. Or, if sharp increases in asset prices were concentrated in some sectors, directed prudential policies (such as greater provisioning, higher margins, or tighter capital adequacy standards) or higher taxes would be called for. If, however, increases in asset prices were more broadly based and related to credit expansion generally, tightening monetary policies would be a more appropriate option.

The guidance zones should be made public. They would provide a signal that departures from these zones would elicit policy action. These actions should become stronger the greater the departures, in strong contrast to past behavior in the exchange market, where a successful attack on a publicly announced margin was rewarded by a withdrawal of the authorities.

Policymakers must combine paranoia and puritanism: paranoia about sharp departures of asset prices from reasonable levels and puritanism in taking away the punchbowl (by tightening prudential and monetary policies) to prevent the bubble from becoming intoxicating. Policy should strive to be as anticyclical as good judgment and common sense will allow, and hence more symmetric than Mr. Greenspan argued for. Mr. Greenspan wanted to address the hangover. It is surely better to avoid drunkenness.


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