Macroeconomists working in the micro-economic foundations framework did not ignore bubbles. Far from it. Dozens of papers were written on the possibility or otherwise of self-sustaining bubbles in asset markets. But, characteristically, the central concern was to determine whether or not bubbles could arise in markets with market participants who were perfectly rational, or nearly so.
There was a rather smaller policy oriented literature, concerned with the question of whether central banks should intervene to prevent the emergence of bubbles, or to burst them early, before they became too damaging. Most of this literature followed the lead of Alan Greenspan, who initially showed some sympathy for the idea of intervention, but eventually became the strongest advocate of the view that central banks should not second-guess markets. But even interventionist participants in the discussion took it for granted that an anti-bubble policy had to be implemented within a policy framework of inflation targeting using interest rates as the sole policy instrument. With these constraints, the … Among the few central banks where the case against bubbles was taken seriously, the Reserve Bank of Australia concluded that the only feasible response was ‘jawboning’ urging investors in real estate to protect themselves against a sharp decline in prices. That did not stop a spectacular increase in prices in the early 2000s, but perhaps jawboning helped to stabilise prices early and reduce speculative lending and borrowing. Certainly, the Australian real estate market survived the crisis, and the Australian economy suffered relatively little damage.
Quote Bell and Quiggin
A realistic theory of bubbles would start with the observation that every bubble has a story to explain why, in the words of …, ‘this time it’s different’. And, for particular assets and markets, sometimes it is different. Those who got in early with shares in Microsoft or Google, or with land in … in … multiplied their money many times over. And although the days of spectacular growth came to an end in each case, there was no bursting of the bubble ending in losses all around.
So a theory of bubbles designed to inform a policy of bubble-bursting must begin with an attempt to understand how ‘this time it’s different’ stories emerge and come to be believed and how to distinguish true, or at least plausible, stories from those that involve a collective abandonment of reality.
Given a better understanding of bubbles it may be possible to develop an analysis of the costs and benefits of pricking putative bubbles. Such a policy reduces the damage from spectacular busts such as the one we have just seen, but it might reduce the returns to long-shot, high-payoff investments.
The last Keynesian golden age ended in stagflation. From the late 1960s onwards, inflation rates rose fairly steadily. For a number of reasons, little was done to constrain inflation initially. These reasons included: the widespread belief in a permanent and stable trade-off between unemployment and inflation; the desire of the US government to fund the Vietnam War without raising taxes or sacrificing the Great Society welfare programs; and the atmosphere of extreme labour militancy associated with widespread revolutionary sentiment which made any form of restraint in wage claims almost impossible. By the time the Bretton Woods system of fixed exchange rates broke down in the early 1970s, the genie was out of the bottle. The attempt by the Nixon Administration to stop inflation through wage and price controls had some initial success, which only made its ultimate failure worse. Although it came relatively late in the inflationary upsurge, and reflected a general boom in commodity prices, the oil shock of 1973, when the price of oil quadrupled overnight, ensured that the era of stagflatio would be long and painful.
The inflationary surge that began the late 1960s has some important lessons that must be learned if we are to avoid similar failures in the future. First, it is important to maintain a focus on keeping inflation rates low and stable as well as on maintaining full employment. Once inflation rates get signficantly above 3 per cent per year, the risk of embedding inflationary expectations becomes greater. It is therefore important to maintain a commitment to low inflation and to adopting the policies necessary to contain and reduce inflation when some shock to the system produces a significant increase in the price level.
Inflation can’t be reduced unless macroeconomic policy acts to constrain demand and excess liquidity . However, a number of countries showed, in the 1980s and 1990s, that a co-operative approach could reduce inflation and unemployment simultaneously. In Australia, following a deep recession in the early 1980s, the newly elected Hawke Labor government reached an agreement with the trade unions referred to as ‘The Accord’. Under the Accord, unions agreed to reduce the rate of growth of wages in return for an increase in the social wage, most notably the introduction of a national system of health insurance, called Medicare.
The Australian Accord went through a series of revisions but ultimately failed when restrictive monetary policy produced a deep recession beginning in 1989. Although policymakers claimed in retrospect that the recession was necessary to bring an end to inflation, this was an ex post rationalisation for policy failure. Inflation rates had fallen steadily in the Accord years, from around 10 per cent a year to 5 per cent.
At about the same time, and facing similar problems, unions and employer groups in the Netherlands negotiated the Wassenaar agreement. In this case, the trade-off for wage moderation was a reduction in working hours and the adoption of a range of measures designed to promote employment growth. The Wassenaar approach survived the stresses of the early 1990s and, according to the ILO was "a ground breaking agreement, setting the tone for later social pacts in many European countries.”