“ASSET PRICES, FINANCIAL
STABILITY AND MONETARY POLICY”
BY F.ALLEN AND K.ROGOFF
Discussion by J.C. Rochet (Zürich)
Prepared for the Riksbank Workshop,
Stockholm November 12, 2010.
What the paper does
Very clear and thorough presentation of the debate
on “what should central banks do about real estate
bubbles?” Discusses facts and theory:
 Reinhart and Rogoff (2009): new evidence that
house price bubbles are frequent and often
provoke banking crises when they burst.
 Allen and Gale (2000,2003,2007): agency theory
models showing how a risk shifting problem in the
banking system can provoke asset bubbles and
ultimately banking crises.
Empirical evidence on house prices
IMF (2004) 18 countries 1971-2003:
Positive autocorrelation (not true for stock prices).
Fundamental factors for rise: income growth, short term
rates, credit growth, population growth (also country
specific factors).
Reinhart and Rogoff (2010) explore behavior of house
prices during banking crises:
On average, house prices fall by 36% and do not recover
before 5 years (15 crises :1898-2001).
Theories of Bubbles (1)
 Almost incompatible with rational
expectations hypothesis.
 However can occur in OLG models (money is
a bubble!). But are OLG models relevant for
house prices and monetary policy?
 Of course bubbles can be due to irrational
behavior.
Theories of Bubbles (2)
Most convincing story: Moral hazard.
Allen and Gale (2000,2003,2007). Three phases:
1.
2.
3.
Bad regulation/supervision or too low refinancing rates leads
banks to lend too much and fuels increase in asset prices .
Bubble bursts due to some exogenous event (bad news).
Wave of defaults by borrowers, propagates to banks and leads
to contraction of credit and deflationary spiral.
Examples: Japan (1980-2000), Nordic countries (1985-1992),
USA(2000)
How to prevent bubbles (1)
“Orthodox” view :
(Bernanke Gertler 2001): “aggressive” inflation
targeting is enough to stabilize output and inflation
when asset prices move up and down.
Reasoning based on simulations of a DGSE model with
informational frictions in credit markets+
exogenous bubble on stock prices.
BG argue that attempts by CB to influence asset
prices undermine its credibility (unintended
consequences on “market psychology” ).
CB should respond to movements in asset prices
only in so far that they impact expected inflation
or output.
How to prevent bubbles(2)
”Pragmatic” view
 If coordination with Treasury and macro-
prudential supervisor does not work well,
monetary policy can be useful to limit
bubbles.
 In that case “leaning against the wind”,
might be justified, provided decision is well
explained to market participants ( Ingves,
2007).
How to prevent bubbles(3):
“Optimistic” view
No need to use monetary policy to prevent
bubbles if :
 Appropriate macro-prudential instruments (LTV
ratios, countercyclical buffers, leverage ratios,…)
are in place.
 Fiscal policy also goes in same direction: limited
deficit, proper real estate taxes, no tax
deduction on mortgage payments,…
 No excessive capital inflows from abroad.
My comments(1)
The authors give a well balanced account of the
different views but they do not take a clear stand in
the debate.
 Which macro-prudential tools are the most
appropriate?
 Can « leaning against the wind » be justified?
 How to guarantee good coordination between
Central Bank, Financial Supervisor and Treasury?
My comments(2)
 Isn’t it dangerous to use DGSE models with
exogenous bubbles and no banking sector to
guide monetary policy decisions?
 Need to develop calibrated models with a banking
sector and endogenous crises in order to provide
quantitative thresholds for use of macroprudential tools.
 Need to elaborate a precise doctrine for the
financial stability mandate of Central Banks.