Remember the debate about whether central banks should prick bubbles? It was not too long ago that simply asking the question incited abuse. While pricking bubbles is now considered a suitable subject for polite conversion, there is still no agreement on what to do or how to do it. Since bubbles are already building up in several segments of the financial markets, it is time to think about this question in detail.
As I argued last week, there are some deep-rooted causes of the proliferation of bubbles – among them the size of the financial sector; the too-big-to-fail problem; and the banks' renewed lust for risk. Governments have not been addressing these causes. Central banks will not provide the cure either, but they can address some of the symptoms. Symptoms matter.
Some economists, reluctant to let go of the comforting world of rational expectations, still tell us it is impossible for a central bank – or anyone else, for that matter – to call a bubble. This is baloney. When looking at house prices, just look at price-to-rent and the price-to-income ratios, sales volumes and credit statistics, and you know everything you need to know. Almost everything else central bankers do is more difficult than calling a housing bubble.