“Should Central Banks Target Asset Prices?”   That is the question addressed by the current symposium in The International Economy (2009, no.4).

My answer: 

Alan Greenspan was right to raise the question “How do we know when ‘irrational exuberance’ has unduly escalated stock prices?”, which is what he actually said in 1996.    But he was wrong to conclude subsequently that monetary policy should ignore asset prices (or even that it should take asset prices into account only to the extent that they contain information about future inflation, as the Inflation Targeters would have it).    More specifically,
(1) Identifying in real time that we were in a stock market bubble by 2000 and a real estate bubble by 2006 was not in fact harder than the Fed’s usual job, forecasting inflation 18 months ahead;
(2) Central bankers do have tools that can often prick bubbles; and
(3) The “Greenspan put” policy of mopping up the damage only after run-ups abruptly end probably contributed to the magnitude of the bubbles ex ante, while yet being insufficient ex post to prevent the crisis from becoming the worst recession since the 1930s.    All three points run contrary to what was conventional wisdom among monetary economists and central bankers a mere two years ago.

As Claudio Borio and Bill White at the BIS pointed out before the financial crisis, many of the worst economic collapses of the last 100 years have occurred after excessively easy monetary policy had shown up in asset prices but not in inflation: US 1929, Japan1990, East Asia 1997, and now the US 2007.

A final point: “Targeting asset prices” is the wrong phrase.  The word “target” (for example, with respect to the money supply, exchange rate, or inflation) implies a number, or at least a numerical range.   I don’t know anyone who thinks that the central bank should contemplate setting a numerical range for the stock market.   Rather, the claim, which I think the evidence now supports, is that central bankers would be well advised to monitor prices of equities and real estate and to speak out, and eventually to act, on those rare occasions when asset prices get very far out of line.

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The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession.   Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse.  The real questions are, rather how macroeconomists (most) could have gotten it so wrong as to believe that:
(i) a severe recession was not even looming ahead as a potential danger, and
(ii) a breakdown of many of the world’s most liquid financial markets, in New York and London, was impossible to imagine.

To anyone wondering about these questions, I recommend Krugman’s essay in the New York Times Sunday magazine, September 6:  “How Did Economists Get it So Wrong?” .
I think his diagnosis of the state of macroeconomic theory for the last 30 years has it right. 

I would only add that he is modest in skipping over one point:  during Japan’s lost decade of growth in the 1990s Paul himself forcefully drew from the Japanese experience the implication that a severe economic breakdown was, after all, possible in a modern industrialized economy – a breakdown that outside the ken of modern macroeconomic theory and was reminiscent of the Great Depression.   But macroeconomics went on as before.   (Likewise with the stock market correction of 1987, the LTCM crisis of 1998, and the dotcom bust of 2000-01.   I do think, however, that our field did a better job with the emerging market crises of 1994-2001, in part because it was considered permissible to argue that financial markets in this case were highly imperfect.)

The list of scholarly economists who in my view deserve kudos for getting important parts of the crisis right ahead of time also includes, among others:

• Robert Shiller – for declaring most visibly that the housing boom was a bubble,
• Ned Gramlich — for pointing out most assiduously that families were being persuaded to take out mortgages that weren’t good for them,
• Ragu Rajan — for diagnosing most accurately the problems of skewed incentives and excessive leverage in the financial system,
• Claudio Borio and Bill White at the BIS — for seeing most presciently the dangers of a monetary policy that ignored asset bubbles,
• Ken Rogoff, for warning most pithily ”This time is not different,” and
• Nouriel Roubini – for forecasting  most fortissimo how serious a future meltdown was likely to be.

Returning to Krugman’s NYT article, even the caricature drawings are good…  except that I have never seen Olivier Blanchard in a double-breasted suit.    But Robert Lucas definitely merits a place there as a leader of the orthodoxy:   When given one page in a recent  Economist essay to defend “freshwater” economic theorists regarding the crisis, he actually thought it was a useful rebuttal to point out that critics are repeating arguments they have made before.  And he also thought it was useful to explain:  “The term “efficient” as used here means that individuals use information in their own private interest. It has nothing to do with socially desirable pricing; people often confuse the two.”  — As if it is not the latter question that the public is wondering about.

(For other economists’ reactions to the Krugman piece, see the National Journal site.)

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