There's No Proof That Easy Money Causes Asset Bubbles, So Stop Worrying About The Wrong Problem

Adam Posen

Adam Posen, a member of the Bank of England’s Monetary Policy Committee, argues in a new speech that easy monetary policy, such as we are experiencing right now in the U.S., doesn’t cause asset price bubbles as many like to suggest.

It might seem like it would, but history and Mr. Posen’s extensive study of Japan say otherwise:

Adam Posen:

In particular, I want to argue that accommodative monetary policy does not cause asset price bubbles. This argument is based on the empirically supported premise that it is private capital flows and differences in productivity that determine current accounts (and asset prices) for the most part.

It was not ‘excessive laxity’ of Japanese monetary policy in 1986–89 which caused the bubble in Japanese equity and real estate prices, nor was it yen appreciation against the dollar which caused the bubble’s impact, except as an induced echo of the asset price boom. As I set out last December, there is no evidence across countries over time that excessive monetary ease was a sufficient condition for the Japanese bubble (“if there is a sustained monetary ease, then a bubble occurs”), a necessary condition for the Japanese bubble (“if a bubble occurs, then there must have been prior monetary ease”), or both.3 The foundation for such claims turns out to be little more than ones of coincident timing—in Japan in the second half of the 1980s, money supply was growing, velocity was declining, and no increase showed up in wholesale or consumer prices, so the contemporaneous growth in real estate and equity prices must have been the result of this liquidity increase.

Yet, this is a rather tenuous link to make. As Japan itself has demonstrated for more than a decade, one can have all these conditions present (expanding money supply, declining velocity, no growth in the price level) and still see no upward trend in asset prices. Without some forward-looking expectations on the part of investors that returns will be rising relative to base interest rates, that profits will be growing, there will be no buying of real estate or of equities.

For monetary policy to be the source of a bubble, the relative price of one part of the economy (here financial and real estate assets) has to be pumped up by a blunt instrument that usually affects all prices in the economy. And it has to do so in such a way that the relative price shift either does not raise expectations of a countervailing shift in monetary policy in the near future (which relies on strange notions of what the imputed future income from increasing land and stock prices will generate), or is expected to only be affected by monetary policy on the upside but not on the down (which there is no reason to believe, if liquidity is the source of the relative price shift in the first place). Either way, this has to take place when we know both analytically and empirically that the relationship between a policy of low interest rates or high money growth and equity or real estate prices is actually indeterminate over time.

We’ve embedded his full speech below. (H/T Alphaville)

Speech 456

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