Marcus Brunnermeier and Isabel Schnabel have a new working paper entitled Bubbles and Central Banks: Historical Perspectives. In their paper, they look at the most prominent asset price bubbles from the past 400 years and how central banks (or their precursors) reacted to those bubbles during their formation and bursting. They suggest that a passive stance of merely cleaning up after the bubble is costly. However, although interest-rate leaning policies and macroprudential tools have helped to deflate bubbles, the implementation of these proactive polices is fraught with danger. What then are central banks to do?
What Brunnermeier and Schnabel ignore is the institutional or regulatory environment which commercial banks operate in during bubbles. As I show in my book Banking in Crisis, asset price bubbles in the UK did not always result in banking crises or economic disaster. The reason for this was that bankers were incentivised to not take excessive risk during the boom by having skin in the game or by stringent asset regulations imposed by the Bank of England. The recent housing boom resulted in the 2008 crisis because of the absence of these two features - bankers had no skin in the game and were not constrained by regulation. This both increased the size of the bubble and made its bursting extremely troublesome for the real economy.
