According to Moody, European central banks had great moderation on the 2004 European irrational exuberance. According to his statement, he believed that economists and policymakers believed in the central banks in preventing economic booms and avoiding economic busts. As one of the profound European scholars, Mody would have considered the historical evidence regarding the emergence of irrational exuberance is often accompanied or preceded by capital inflows, monetary policy, vast lending, and deregulations or financial innovation (Mody, 2018).
During the 2004 financial crisis, central banks were highly dependent on the Greenspan point of view regarding monetary policy and they never attempted to prevent the emergence of the irrational exuberance. Rather, the central banks cleared up the mess after the break of the financial crisis just as they did in the 2000 bubble. Moody should have considered the way central banks conducted the ex-post cleanup quite successful but did not bother in the moderation and prevention of the irrational exuberance as he had mentioned. Central banks ignored the reality that the 2000 irrational exuberance was largely financed by equity rather than debt as the 2004 irrational exuberance (Mody, 2018). However, the 2004 irrational exuberance has openly indicated that huge costs that can arise from irrational exuberance.
The two irrational exuberance in the 2000s tilted the view towards more central bank intervention indicating that Greenspan’s view has changed to a new consensus closer to the BIS view. The central banks did not have the measures on how to react to asset price bubbles and could rather use the newly created micro-prudential instruments that can serve the purpose. The central banks should have also considered the asset price distortions in their decisions. The central banks should have taken several considerations in moderating the irrational exuberance that is not visible in this case as Moody states (Shiller, 2015). The assets should have been well characterized together with their holders, policy environments at the time that the bubbles emerged, crisis severity and policy responses.
The central bank instead of cleaning the mess in the two in 200 and 2004 it could have used other policies such as the central bank communication, macro-prudential measures, and the leaning interest rate policy. The leaning interest rate policy would have involved several types of measures that in the current world would have been called the quantity or macroprudential instruments. They involve putting limitations in place on the loan-to-value ratios for the financial institutions or banks and place restrictions that are explicit on credits. On some occasions, leaning is being used in a narrow sense in that it is inclusive of shifts in the interest rates (Mody, 2018). Macroprudential instruments are in a way considered as leaning instruments.
The central banks should have used communication by talking down the assets that have been overvalued. Having in mind that private entities or agents have wide access to the same information as a central bank it is not outright whether just statements with no information regarding the future interest rate movements or the macro-prudential policy responses can in real sense change asset prices. Moody should have considered that the rational investors may know that the bubble market will later come to failure but rather chose not to exit since they cannot synchronize their deeds with the other contributors to the irrational exuberance. A declaration by the central bank can coordinate the exit behavior and result in a fast deflation of the bubble. The central banks that Moody sees to have contributed much in the moderation of the irrational exuberance neglected the aspect that could have saved the situation better than a cleanup (Shiller, 2015).
Globally there have been examples from different countries where the leaning interest policy has been successfully utilized to mitigate financial m crisis and irrational exuberance. For instance, in the Australian irrational exuberance in the early 2000s. The Australian Reserve Bank was alarmed by the inclining prices of property and the higher credit expansions. Initially, the Reserve bank reverted through communication to lay more emphasis on the long term hazards from the developments (Lantis, 2011). Afterward, the Reserve Bank tightened its interest rates policy in various stages commencing in mid-2000. However, the steps were motivated officially by the inflationary pressures and not explicitly aimed at the cost of assets and their impact was deceleration of the property prices without disruptions that might be severe. The leaning policy success in Australia is much associated with its timing. The Reserve Bank noticed the problem and responded to it at a very early stage that was long before the irrational exuberance that could be a dangerous proportion to the economy (Lantis, 2011). Therefore, the deflation of the irrational exuberance needed no substantial rate hikes. Another case was the Norwegian crisis in 1899 where the interest rates mitigated irrational exuberance. However, it did not have more evidence clear as the Australian case (Shiller, 2015).
The European central banks praised by Moody for moderating and preventing the irrational exuberance would have utilized leaning interest rate policy that its implementation is far from trivial. The central banks should have been monitoring their property market at all times to ensure that their economies do not land to the risks of irrational exuberance. Also, continuous monitoring of the property market by the central banks will allow the banks to implement leaning interest policy efficiently and make them effective and avoid its strong complications if lately applied.
The central banks should have controlled the financial bubbles and the bubble asset to moderate or prevent the irrational exuberance as claimed by Moody. There is much relevance in the financial bubble than it is in the bubble asset type. The central banks should have taken into consideration that bubbles in stock might be as risky as the bubbles in the property or real estate in a situation where the financing runs in the financing system. The falling out of irrational exuberance seems to be the most severe when the bubble is accompanied by vast lending, high leverage, and market players liquidity mismatch and banks together with the microfinance participating in the buying frenzy (Shiller, 2015).
Finally, the activities that the central banks conducted of cleaning up the mess were likely to be more expensive than the other measures that could be taken. It can be proven through historical evidence from various episodes and suggest that the policy measures in most cases can be effective in crisis mitigation. Generally, the evidence of thrust not considering the complications of changes and precise identification of bubbles that are accompanied by challenges of gently deflating them (Mody, 2018). Such proactive approaches that the central banks’ utilized remain s serious impediments.
Lantis, J. S. (2011). Irrational Exuberance? The 2010 NPT Review Conference, Nuclear Assistance, and Norm Change. The Nonproliferation Review, 18(2), 389-409.
Mody, A. (2018). EuroTragedy: a drama in nine acts. Oxford University Press.
Shiller, R. J. (2015). Irrational exuberance: Revised and expanded third edition. Princeton university press.
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