Asset Price Booms: How Can They Best Be Managed?

• Author: Giovanni Dell’Ariccia
• Position: Deputy Division Chief in the IMF’s Research Department
• Pages: 34-36

Page 34

Not all booms are alike— making the right call on which policies to deploy depends on how assets are held and who is exposed to a possible bust

ASSET price booms are fairly common occurrences in market economies. One of the first to be documented was the tulip mania of 1637 in Holland, when, at its peak, contracts sold for more than 10 times the annual income of a skilled craftsman. One of the most recent was the U.S. housing boom of the past decade, whose bust triggered the current global economic crisis.

But not all booms are alike. Some booms have been associated with crises and episodes of financial distress. But others have led to growth and the creation of tangible long-term assets, such as during the “railway mania” that took place in the 1840s in Britain. The scope and severity of the current crisis have reignited the debate over whether economic policy should be concerned with asset price booms and increases in leverage. If so, does this fall under monetary policy or should the burden be on regulatory measures? What, if any, should be the role of fiscal policy? This debate will continue to occupy economists and policymakers for a while, but a few preliminary conclusions can be drawn.

Leveraged booms more dangerous

What matters may be not so much the asset price boom in itself, but who holds the assets and the risk, how the boom is financed, and how an eventual bust may affect financial institutions. The degree of leverage associated with the funding of a boom and the degree of involvement of banks and other financial intermediaries will determine the magnitude of balance sheet effects and the dangers to the supply of credit in a bust.

As we have learned in recent months, busts are far more costly when banks are implicated in the boom and prices are supported through credit from highly leveraged institutions. This is because when asset prices deflate, the balance sheets of borrowers, and thus those of banks, deteriorate sharply (especially when maturity mismatches are pervasive), resulting in a credit freeze that can have a severe impact on economic activity. During an upswing, higher collateral values relax credit constraints. The resulting increase in credit in turn contributes to fuel the rise in asset prices. The opposite spiral can ensue in a downswing, as falling collateral values prevent borrowers from obtaining credit, further depressing asset prices (Kiyotaki and Moore, 1997).

In contrast, booms with limited leverage and bank involvement tend to deflate without major economic disruptions. For example, the bust of the dot-com bubble in 2001 was followed by a relatively mild recession. In that boom, banks played a minor role. The sharp fall in stock prices did have a wealth effect, but it didn’t result in the kind of negative feedback between deteriorating borrower and lender balance sheets that has characterized the current crisis. For this reason, it did...