There’s never a good time to burst an asset bubble

One of the newly-formed pieces of conventional wisdom emerging from the current financial morass is that the Federal Reserve and other central bank heads should be more alert to spot asset bubbles and pop them before things really get out of hand. This is one of those pieces of advice that sounds great in theory ...

By Daniel W. Drezner, a professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University and co-host of the Space the Nation podcast.

November 12, 2008, 9:24 PM

One of the newly-formed pieces of conventional wisdom emerging from the current financial morass is that the Federal Reserve and other central bank heads should be more alert to spot asset bubbles and pop them before things really get out of hand. This is one of those pieces of advice that sounds great in theory but fiendishly difficult to apply in practice. When, exactly, is a bubble a bubble? Of course, proponents of this strategy still sound smart in proposing it, because their counterfactual sounds like it should be better than the current situation. I bring this up because of David Piling's discussion in the Financial Times about China's fiscal stimulus. Among other factors driving Beijing is that it's now paying the price for its efforts to pop an asset bubble: The sudden slowdown was not made in Wall Street. It originated in decisions adopted last year to take the heat out of a boiling property market – partly because of fears, now evaporated, about inflation. Banks were told to curtail lending to the property sector. Property developers were obliged to build lower-income housing and buying a second home was made more difficult. China’s policies contrasted with those in the US and Europe, where it was beyond the remit of independent central banks to try to tame asset prices. But bursting bubbles, even in a command economy, is not that easy. Instead of taking the froth off the property market, Beijing has drained it dry. “They thought they were fine tuning,” says Arthur Kroeber, managing director of Dragonomics. “But China remains a boom-and-bust 19th century economy.” If attempts to ease growth lower have misfired, efforts to ratchet it up again may not go so well either. China is pretty different from the U.S. and Europe, so I'm wary about the validity of this comparison. Still, it's worth mulling over.

The sudden slowdown was not made in Wall Street. It originated in decisions adopted last year to take the heat out of a boiling property market – partly because of fears, now evaporated, about inflation. Banks were told to curtail lending to the property sector. Property developers were obliged to build lower-income housing and buying a second home was made more difficult. China’s policies contrasted with those in the US and Europe, where it was beyond the remit of independent central banks to try to tame asset prices. But bursting bubbles, even in a command economy, is not that easy. Instead of taking the froth off the property market, Beijing has drained it dry. “They thought they were fine tuning,” says Arthur Kroeber, managing director of Dragonomics. “But China remains a boom-and-bust 19th century economy.” If attempts to ease growth lower have misfired, efforts to ratchet it up again may not go so well either.

China is pretty different from the U.S. and Europe, so I’m wary about the validity of this comparison. Still, it’s worth mulling over.

Daniel W. Drezner is a professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University and co-host of the Space the Nation podcast. Twitter: @dandrezner