Fed's Williams: Asset Bubbles, Crashes Will Continue

Asset price bubbles and crashes will occur in the future, according to Federal Reserve Bank of San Francisco President and CEO John C. Williams, but research may help unlock "their secrets."

"A cursory reading of the academic literature on asset prices reveals a litany of puzzles, conundrums, paradoxes, and anomalies," Williams Monday told the National Association for Business Economics' 55th annual meeting. "Much of the research on asset prices continues to rely on highly stylized models with identical agents, rational expectations, and optimizing behavior. According to the prevailing view, asset price surges that many would perceive to be bubbles are not really so. Instead, they are seen to reflect the influences of fundamental forces, such as a decline in risk appetite."

But, later investigation "not only recognizes that asset price bubbles really do form, but also holds great promise in unlocking their secrets and identifying them," he said.

"The lesson from history is clear: asset price bubbles and crashes are here to stay," Williams said. "And the events of the past decade demonstrate the enormous human costs of asset price bubbles and crashes."

To minimize the impact of bubble bursts, Williams said, "we need to acknowledge that investors and financial markets do not behave the way rational asset price theory implies. We need to incorporate these channels into the models we use for forecasting, risk analysis, and policy evaluation. This opens up a world where actions, including regulatory and monetary policy measures, may have unintended consequences-such as excessive optimism, risk taking, and the formation of bubbles-that are assumed away in standard rational models."

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