Ack! There’s no “asset bubble” variable in the Taylor rule

I agree with Prof. Tabarrok at MR. I did a year of monetary theory classes and not once did we talk about the Fed’s role, one way or the other, in asset bubbles. There’s something wrong with the theory or there’s something wrong with UCD’s monetary economics curriculum.

6 thoughts on “Ack! There’s no “asset bubble” variable in the Taylor rule”

  1. No, I mean, there are those models of “rational bubbles” which have a knife edge sort of property, and beyond that, I know of no convincing formal theory or empirically successful investigation in the phenomenon. Hence the is-it-or-isn’t-it-a-bubble talk.

    You see this all the time in housing… a relatively illiquid market, few transactions, and people holding out for high prices. There’s great uncertainty and lots of rumors about demand.

    I guess the problem here is suboptimal portfolios. I don’t think there’s anything that the Fed can do about that.

  2. More accurately, suboptimal portfolios marketed (and leveraged as collateral) as optimal portfolios, if I understand the issue correctly. The fed does seem to have a role in limiting fraud. I’m just worried that any reforms they make will just create a giant regulatory Maginot line.

  3. swong, the problem with that view is that the group of sophisticated sellers of said “suboptimal portfolios” were also the group of supposed unsophisticated buyers. Banks were repackaging these things and selling them to other banks. Wouldn’t the buyers have an incentive to understand the risk profile of the assets they were buying?

  4. Source(s)? My understanding has been that the portfolios were laundered into higher-rated packages and re-sold to totally different parties. The unsuspecting end buyers weren’t the banks, they were the investors in funds that ultimately bought these mortgages and the shareholders of certain investment banks.

    In the short run, it seems foolish to spend time investigating the risk profile of assets like these. While you conduct a full risk investigation on something that’s deemed “AAA” by the powers-that-be, your competitors will buy and sell a billion dollars worth of paper assets. Why bother checking the actual value of anything when you can just flip it in 24 hours for huge profits?

    Admittedly, I’m only slightly better informed about the issue than someone who hasn’t even heard of the issue. From my point of view, it just looks like a high stakes game of musical chairs.

  5. Evidence: if you’re dispensing with Billions (notice the B) of dollars to buy something, you have an incentive to make sure you understand the probability with which that something will disappear.

    “you can just flip it in 24 hours for huge profits” So high-finance is an elaborate episode of Flip That House? This could be.

    Your’s is the same story as Kindleberger’s (who knew more than anybody about the issue of asset bubbles) in his Panics, Manias and Crashes. Actually, it sounds like a dull topic, but this is a great book. History repeats itself in extremely entertaining ways.

  6. If you’re dispensing with Billions of dollars (pinky in mouth) to buy something, your only goal is to turn that into at least Billions+1. All other incentives are secondary. Why blow the whistle on a bad investment when it will tank your firm and cost your career? Better to keep running around and hope that you have a chair when the music stops.

    Crowds of people can groupthink themselves into some really amazing delusions. Even scientists aren’t immune to this. Why are business school grads and accountants any better? I don’t think investigators will uncover a grand conspiracy to defraud investors. Probably evidence of a few hundred thousand tiny conspiracies.

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