It is not so difficult to identify an asset bubble.

Andrew Smithers
Financial Times (Letters) , 11th November 2009

All asset bubbles present a risk to the economy, contrary to the views expressed in Frederic Mishkin’s article of 10th November. Asset prices are a key transmission mechanism whereby changes in interest rates affect the real economy. Rising asset prices encourage investment and discourage savings so they boost demand. Asset prices tend to rise when interest rates fall, but the effect is ephemeral, as there is no long-term relationship between asset prices and interest rates.
This transmission mechanism is weakened and can break down, as we have recently seen, if asset prices rise to bubble levels, as they then fall whether or not central banks cut interest rates. The stock market bubble which peaked in 2000 was not just “a tech-stock bubble”. The US market became in aggregate more overvalued than at any time before, including its previous peak in 1929.
When the stock market bubble of 2000 broke, the subsequent recovery required a large fiscal stimulus and an excessively easy monetary policy. The consequence was the asset bubbles in shares, houses and credit that burst in 2007 and produced the current problems.
Professor Mishkin wrongly claims that “asset bubbles of this type are hard to identify”. Bubbles can only occur if prices move away from value, so that the identification of value as distinct from price is a necessary requirement for the identification of all asset bubbles. As value does not depend on credit conditions, the method of identification must be the same for all bubbles independent of any assumptions about their type.
As bonds, shares and gold have all risen in price, it seems likely that quantitative easing is responsible for the current rise in asset prices. If it has, this has justified the policy, as the boost to demand from a rise in asset prices was clearly desirable and, because of past policy errors, was not possible through the more orthodox approach of lowering interest rates.
It may well be premature to tighten monetary policy, but the situation is nonetheless dangerous. Economic recovery from the recession following the next bubble collapse will be even more difficult than this one has proved.