recurrent bubbles

“…once a crisis is under way, even drastic cutting of central bank interest rates and massive injection of liquidity may have limited effects in stimulating credit markets and investment. The main effect may turn out to be the mother of all bubbles in the next several years, ending in a bigger crash. This underlines the importance of not letting bubbles develop in the first place.

…the crisis shows the hazards of an economic growth model based on the growth of finance and housing, and on the international system’s tolerance of large external deficits.”

Robert Wade writing on the Global Financial Crisis in 2008.

Reading this passage got me thinking about whether we have fully thought through the consequences of our responses to the Global Financial Crisis (GFC).

It is argued by some that the GFC itself was partly caused by very low interest rates set by the Federal Reserve in the wake of the dot com bubble (among other things). Inflation was low, so Alan Greenspan kept interest rates low throughout the early- and mid-2000s. These low interest rates contributed significantly to the consumer debt and housing bubbles underlying the GFC.

How are we to know we aren’t going down this road again? Looking ahead, what are the consequences of an expansionary monetary policy for the future? How are we to know that through quantitative easing we aren’t creating yet another asset bubble, that might contribute to another financial crisis some time in the future?

Edited 8 October 2013

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