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Battling Bubbles

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Last week, I argued against any premature interest rate rises by central banks. A couple of objections to extremely low interest rates—on the basis that they are ineffective in spurring current growth—were addressed. However, there is a potentially more pressing, and certainly quite well publicized, fear regarding interest rates.

Many contend that reserve banks have kept benchmark rates artificially low through their unprecedented quantitative easing programs. Some worry that these low interest rates, and asset purchases by central banks, could be distorting markets and precipitating another calamitous bubble. 

At a basic level, QE floods the financial system with new money in the hope that this will give succor to bank lending and consumer spending. This is all meant to boost confidence in the economy, which creates a virtuous cycle of more lending and more spending. 

However, the resulting low interest rates may also encourage unproductive over-investment in the stock and real estate markets and in emerging economies ill-equipped to handle sudden cash flows. Ultimately, this can lead to the formation of the kind of dangerous bubble seen in the real estate market in 2006. 

There is also an argument to be made that central banks are directly responsible for creating a bubble in at least government bond markets, with massive purchases having pushed interest rates into negative territory in some developed economies. 

Widespread concern has been expressed that financial markets have become dependent on quantitative easing measures to prop up prices. If markets are reliant on easing, then any indication of a tightening would depress valuations. Indeed, earlier threats by the Fed to raise interest rates caused serious jitters in global stock markets. 

Fortunately, it seems like most investors have already “priced in” small rate increases in the coming future. In essence, market prices reflect, to an extent, an expectation that rates will rise relatively soon. This should prevent any imminent increase from creating serious instability.   

That said, concerns about frothy conditions in asset markets are potentially well-founded. Cyclically adjusted—corrected for fluctuations of the business cycle—stock market valuations at unusually high levels, particularly in the United States. The consequences of a bubble would be devastating, so corrective measures are imperative. 

Simply raising interest rates would, of course, do the trick. The excess money in the system would be removed, and there would be reduced investment in assets. However, interest rate adjustments are an incredibly broad tool. As discussed last week, the ramifications to the economy of a premature increase in rates could be severe.  

There does exist a more focussed and nuanced alternative to interest rate increases: macroprudential policy. The word is a mouthful to say, and indeed the measures can be rather complex in nature too. These policies are measures targeted at specific problems within the financial markets. They differ from regulative measures in that they target instability in financial markets at large, instead of individuals or firms in particular. 

In brief, such policy measures can include loan-to-value ratios to minimize the risk in property lending, liquidity requirements for banks, and mandatory provisions for banks to build capital buffers during times when the economy is doing well. These measures can, in theory, effectively stymie the inflation of bubbles and ease stress on the financial system. 

A number countries have experimented with macroprudential measures, sometimes with mixed results. It is difficult to muster sufficient evidence regarding the efficacy of the constellation of macroprudential policies. Those outlined above, however, are generally regarded as successful. A more detailed discussion of such measures would fill pages.


The promise in such sophisticated policy lies primarily in its ability to reduce systemic risk in the financial system, particularly in areas prone to distress, without jeopardizing an economic recovery. The aftermath of the previous financial crisis compelled central banks to create and implement novel tools. To prevent the next one, they may have to do the same again.  

A version of this article appeared in the South China Morning Post's Young Post on Thursday, October 27. http://yp.scmp.com/over-to-you/columns/article/104699/policies-help-battle-against-bubble

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