Wednesday, May 16, 2012

National Bank of Belgium: Liquidity Doesn't Always Cause Asset Bubbles

A 2007 empirical study by the National Bank of Belgium on the effects of excess liquidity finds that only under certain conditions does excess liquidity actually lead to an asset bubble. The idea that most high-cost booms are preceded by high money growth has been well elaborated by economic theory. However, this does not necessarily imply that all periods of excess liquidity signal an imminent asset price boom. In fact only 1/3 of all periods of excess liquidity analyzed by this empirical study lead to an asset bubble. It is a warning against naive monetary analysis.

The findings of this paper are that an asset price boom arises only under a combination of events. The conditions under which excess liquidity might lead to an asset price boom (a bubble), are when the period of excess liquidity is prolonged and is accompanied by strong real GDP growth, low inflation, and credit growth.

In looking at what this means for monetary policy, it means simply that central banks can afford to act without fearing the automatic rise of inflation or asset bubbles in reaction to any effort to improve sluggish economic growth. The threat of bubbles looms large when excess liquidity persists on the market for long periods, during episodes of strong economic growth. In looking at what it means for financial regulation, it means that asset price bubbles can also be prevented or possibly even dismantled by better regulating the credit markets.

Essentially, the results of this study confirm the conclusions outlined by the Quantity Theory of Money and by the Phillips Curve, albeit on a micro scale. That is, increases in liquidity might influence prices, but only after other avenues have been exhausted. Looking at the graph above, we can say that while at point B, we should feel confident in the usefulness of monetary action, without immediately worrying about price levels. We should not pretend that we are at point A when it simply isn't the case.  

This paper analyses the relationship between the prevailing liquidity conditions (such as measures of money, credit and interest rates) and developments in asset prices from a monetary analysis perspective. After having identified periods of sustained excess liquidity, we analyse under which conditions they are more likely to be followed by an asset price boom. The results from a descriptive analysis of the developments in a number of macroeconomic and financial variables suggest that periods of sustained excess liquidity that are accompanied by strong economic activity, low interest rates, high real credit growth and low inflation have a higher likelihood of being followed by an asset price boom. This conclusion is also confirmed by a logit analysis.
The National Bank of Belgium is Belgium's central bank and lender of last resort. It is part of the European System of Central Banks 

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