Vladimir Asriyan, Luca Fornaro, Alberto Martin, Jaume Ventura,
Based on: The Review of Economic Studies, Volume 88, Issue 3, May 2021, Pages 1418–1456, DOI: https://doi.org/10.1093/restud/rdaa045
We live in a “bubbly” world, with low real interest rates and volatile asset prices. Over the last three decades, real interest rates have declined throughout industrial economies. Most recently, Japan, the United States, and parts of the Euro Area have all exhibited large and recurrent booms and busts in real estate and stock market prices, commonly referred to as bubbles.
How should monetary policy be conducted in this world? Much of the debate around this question has focused on the use of interest rate policy to prevent or control the appearance and growth of bubbles. But there is an alternative aspect of policy that has been central to recent collapses in asset prices: they were accompanied by a fall into a liquidity trap -- a situation in which conventional monetary policy no longer works because the nominal interest rate has hit the zero lower bound -- and a substantial growth in central bank balance sheets. As the value of private assets evaporated, market participants turned to central banks for stores of value; the banks supplied them by expanding the monetary base. Thus, a key aspect of monetary policy in dealing with bubbles and their aftermath has been precisely to supply stores of value.
This role of monetary policy raises a number of fundamental questions. When is money valuable as a store of value? How is this value connected to the rise and bursting of asset bubbles? Can the central bank always supply stores of value? And, should it do so?
Bubbles and money: The view
Consider a world in which some agents (entrepreneurs) borrow to take advantage of productive investment opportunities, while other agents (savers) save because they lack these opportunities. Normally, entrepreneurs would supply ‘‘backed’’ assets, that is, assets backed by the fruits of their investment, and savers would demand these assets as stores of value. But, what if entrepreneurs’ ability to credibly promise these fruits is limited by frictions, such as imperfect contract enforcement? Since savers still demand stores of value, these frictions depress real interest rates and open the door for ‘‘unbacked’’ assets to be issued, that is, assets that are backed only by expectations of their future value. Such unbacked assets could be the part of a company’s stock that is overvalued, debt issued by the private sector that is expected to be rolled over indefinitely, or – to cite more recent examples – a cryptocurrency or nonfungible tokens (NFT).
The dynamics of unbacked assets are driven by two forces, with differing effects on economic activity. First, their creation generates a wealth effect. New unbacked assets generate a rent for their creators because they are costless to produce and yet have a positive market value. For example, if an entrepreneur issues debt that is unbacked because the market expects it to be rolled over indefinitely, then she receives a pure rent. Second, the existence of unbacked assets generates an overhang effect. Old unbacked assets must be purchased and this diverts resources that could have been used for productive investment. In our example, the savers that eventually finance the roll-over of the entrepreneur's debt must divert their funds from other uses.
Up to now, we have considered only unbacked assets issued by the private sector. We refer to these as bubbles. But unbacked assets can also be created by the central bank, and we refer to these as money. Money is always demanded for transaction purposes, but it can also be valued as an asset if its expected rate of return (the inverse of the rate of inflation) equals the real interest rate: in this scenario, savers tend to hoard money, so the economy is in a liquidity trap.
Both bubbles and money have wealth and overhang effects, but they differ in two crucial respects. The first difference is distributional. While the wealth effect of bubbles accrues to entrepreneurs, thereby expanding investment, the wealth effect of money (i.e., seigniorage) accrues to the government. The second difference lies in the drivers of their supply. While bubbles are driven by market psychology, the money supply is under the control of the central bank.
We show that the central bank both can and should intervene in a bubbly world. First, the central bank can intervene and adjust the money supply to provide unbacked assets over and above those supplied by private bubbles. Should it choose to do so, moreover, the central bank can fully stabilize the economy's total supply of unbacked assets at a target of its choice! Second, the central bank should intervene in the bubbly world. The reason is that unbacked assets are beneficial insofar as their overhang effect crowds out dynamically inefficient investments. By adjusting the money supply in response to bubbly fluctuations, the central bank can ensure that the total supply of stores of value is always high enough to eliminate such investments.
Figure 1 illustrates the evolution over time of the aggregate value of the bubble and of real money balances during a bubbly episode, that is, an episode during which the value of private assets increases gradually until it collapses back to its fundamental value. The blue line depicts the case in which the central bank sets a positive nominal interest rate, so that the economy is outside of the liquidity trap and only a small amount of money is held for transaction purposes. The dashed green line depicts instead the case of the optimal monetary policy, in which the nominal interest rate is equal to zero, the economy is in a liquidity trap, and money is also held as a store of value. The figure illustrates two key points. First, the value of money balances is always positive under the optimal policy, as the central bank always supplies stores of value to complement those provided by the private sector. Second, the stock of real balances responds to the bubble, decreasing when the bubble expands and rising when the bubble crashes. In fact, the total supply of unbacked assets is fully stabilized by the optimal policy.
The main takeaway is that central banks have a key role to play in the bubbly world: to supply assets. This resonates well with the conduct of monetary policy in the wake of the Global Financial Crisis (GFC), when central banks expanded their balance sheets in response to the bursting of bubbles. But it is also quite different. In a standard balance sheet expansion (i.e., quantitative easing), the central bank issues some assets and purchases others, leaving the net supply of assets available to the private sector unchanged. In the bubbly world, instead, the key aspect of welfare-enhancing interventions is that they expand the net supply of assets available to the private sector, thereby soaking up inefficient investment.
These findings also resonate well with the recent inflationary experience across much of the developed world. Many economists found it intriguing that the post-GFC increase in the monetary base did not translate into higher inflation. But this is exactly what we would expect in the bubbly world: insofar as the economy remains in a liquidity trap, a monetary expansion is not inflationary because it simply provides stores of value that the private sector demands. However, things change when the economy exits the liquidity trap. Once money is no longer useful as a store of value, its demand collapses, and a spike in inflation is necessary to adjust the supply of real balances.
In recent decades, a lot of emphasis has been placed on the role of monetary policy as a tool to achieve price stability. Although this view is clearly useful, it is incomplete. In a bubbly world, money also plays an important role as a store of value and monetary policy is a useful tool to control the size of asset bubbles.
ICREA Research Professor at CREi, and Affiliated Professor at Barcelona School of Economics
Director and Senior Researcher at CREi, and Research Professor at Barcelona School of Economics
