When Asset Booms Go Bust

Voxeu.org has a fitting post up for the economic times on the threat posed to the economy by deflation. Everything you read and hear from the mainstream media, which is of course force-Fed a diet of Keynesian economics, is that deflation is a scourge that must be battled with the full arsenal of the monetary authority.

The economic devastation during the Great Depression is always dragged out as the poster child for why deflation is so destructive. But what if the Great Depression was an outlier?

Four researchers from the Bank for International Settlements find that historically, consumer price deflations have a mostly benign impact on economic growth, but asset price busts always weaken economic growth. To wit:

The results are actually starker if we consider persistent deflations. Here we examine the behaviour of output following peaks in the respective CPI and asset price indices (Figure 3). We find that the change in growth in the wake of persistent CPI deflations is uniformly statistically insignificant except for short horizons during the postwar era – where, however, deflation appears to usher in stronger output growth. By contrast, output growth always weakens in a statistically significant way following equity and property price peaks. Taken at face value, the output slowdown in the wake of both equity and property price peaks is sizeable. For example, in the full sample, the slowdown is quite similar for both sets of asset prices – cumulative growth is about 10 percentage points lower by the end of the five years.

So we have the world’s largest central banks pumping the global financial system full of liquidity to inflate asset prices in an effort to raise what is coined “dangerously low inflation.” Yet if the asset boom goes bust, we should anticipate that the economy will be damaged much more than it would be if there were a little bit of consumer price deflation.

In investing, risk should always come before potential return. The world’s central bankers should approach monetary policy in the same fashion.

You can read the full post here.