A central bank must switch to a liquidity-restricting monetary policy as soon as the first signs of overheating and the danger of a bubble become apparent (“take away the punchbowl [the punchbowl: the drunkenness-inducing drinks, read: the cheap money] just as the party got going”). This rule of thumb was established by William McChesney Martin (1906-1998), who served as head of the Federal Reserve from 1951 to 1970. – The counterargument was that a restriction of liquidity increases the interest rate, thus making investment more expensive and therefore entailing the risk of unemployment. However, it should be noted that a slight rise in unemployment now entails less welfare losses than more unemployment in the course of a bear market or even a financial crisis, such as the one that followed the subprime crisis. – Of course, we must not overlook the fact, proven many times in financial history, that a central bank cannot prevent a bubble in principle. If – and indeed worldwide – a large number of small investors expect to finally become rich by investing in the stock market, they will take out loans from the banks to finance such transactions. Even a very high interest rate does not deter investors in this case. All the less so if – as is characteristic of a bubble – the price of the asset in question – such as tulips, real estate, shares, commodities – increases by leaps and bounds due to the demand of very many speculators. Leaning against the wind is futile in such cases. The only thing left for the central bank to do is cleaning up after. – See bubble, speculative, dotcom bubble, financialization, milkmaid bull market, commodity bubble, monetary policy, buffer, countercyclical, stability fund, European, tulip crash, exuberance, unreasonable, asset bubble.
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University Professor Dr. Gerhard Merk, Dipl.rer.pol., Dipl.rer.oec.
Professor Dr. Eckehard Krah, Dipl.rer.pol.
E-mail address: info@ekrah.com
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