Wednesday, 13 November 2013

Bubbles and central banks – is there a connection?

By Dr Frank Shostak

According to the popular way of thinking, bubbles are an important cause of economic recessions. The main question posed by experts is how one knows when a bubble is forming. It is held that if the central bankers knew the answer to this question they might be able to prevent bubble formations and thus prevent recessions.
On this, at the World Economic Forum in Davos Switzerland on January 27, 2010, Nobel Laureate in Economics Robert Shiller argued that bubbles could be diagnosed using the same methodology psychologists use to diagnose mental illness. Shiller is of the view that a bubble is a form of psychological malfunction. Hence the solution could be to prepare a checklist similar to what psychologists do to determine if someone is suffering from, say, depression. The key identifying points of a typical bubble according to Shiller, are,

  1. Sharp increase in the price of an asset.
  2. Great public excitement about these price increases.
  3. An accompanying media frenzy.
  4. Stories of people earning a lot of money, causing envy among people who aren’t.
  5. Growing interest in the asset class among the general public.
  6. New era “theories” to justify unprecedented price increases.
  7. A decline in lending standards.
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