To pop or not to pop, that is the question for central bankers.
Whether 'tis wiser for the economy to suffer the booms and busts of irrational exuberance, or to take arms against a sea of bubbles and by opposing end them. In other words, should the Federal Reserve only try to clean up after a bubble has already popped, or should it actively try to pop bubbles so the clean-up is easier?
Now, as you might have guessed, the choice isn't so simple. While nobody thinks policymakers can afford to ignore financial froth anymore, the economy can't afford for them to pay too much attention to it, either. Raising rates would eventually burst any bubbles we may be experiencing -- but that'd come at the cost of higher unemployment. Regulating away a bubble makes more sense, since it wouldn't hurt the rest of the economy, but it's not clear that regulators can actually pull this off. So it's a choice between a tool that would work too well, and a tool that might not work well enough.
What Sweden tells us about bubbles
That's a lesson Sweden has more than learned. Sweden has become the unlikely guinea pig for raising rates to fight a bubble. Now, until a few years ago, Sweden had been what Neil Irwin called the "rockstar of the recovery": aggressive fiscal and particularly monetary stimulus had helped it bounce back from the crisis faster than almost any other country. But, despite still-low inflation, its central bank, the Riksbank, began to worry that it had bounced back too fast, and that households were taking on too much debt, up to 174 percent of their income. That's why, over the protests of Lars Svensson, one of its deputy governors and one of the world's leading monetary economists, Sweden's central bank began hiking rates in July 2010. Well, part of the reason. As Paul Krugman points out, the Riksbank initially said that it needed to raise rates to keep inflation in check. But then, when inflation refused to show up, it said it still needed to do so, this time to keep a housing bubble in check. It's what Krugman calls "sado-monetarism": a pathological fear of low rates that leads to a never-ending search for a reason, any reason, to raise them.
This didn't just cripple Sweden's recovery. It crippled Swedish households too. And in doing so, it paradoxically made a crisis more likely. See, Sweden's economy had been doing better than most others, but not so much that it could withstand seven rate hikes while joblessness was still high. This premature tightening kept unemployment from falling much further, and made inflation fall well below target—into negative territory.
And this is the key point: low inflation means higher real debt burdens. So raising rates to try to stop households from taking on more debt actually increases their inflation-adjusted indebtedness. It's a policy with almost all costs and no benefits—and that's according to the Riksbank's own calculations. As Svensson points out, the central bank estimates that the benefits of raising rates to try to pop a bubble are only 0.14 percent of the costs. No wonder the Riksbank recently reversed course, and cut rates back near zero.
Containing bubbles, not popping them
So Sweden isn't trying to pop its bubble anymore. It's trying to make it less dangerous instead. It's using what economists call "macroprudential regulations" to try to limit risky debt—for example, by making borrowers pay back their mortgages faster. As David Wessel points out, this is the same approach that Fed Chair Janet Yellen, ECB chief Mario Draghi, and Bank of England deputy Jon Cunliffe have all endorsed recently. That's because central bankers realize they can't make policy that helps the financial economy but hurts the real one without it eventually rebounding back onto the financial one, too. Instead, they need to give the real economy the policy it needs, and the financial one the regulation it does. That could be everything from increasing bank capital ratios to increasing down payment requirements when housing prices are booming.
It's a matter of slowing, not stopping, the bubble—and surviving it if it does pop.