In today’s random and dynamic world, investment is regarded as one of the key methods of saving one’s life. People invest in financial instruments so as to safeguard their future and meet any unforeseen requirement which may arise in future. It is needless to say that the global financial market has evolved a long way and numerous investment instruments are available today in the market unlike few like land, gold etc. as were present in earlier days. In order to generate high return, we have a  wider range of assets today than ever before. People have increasingly diversified asset holdings from investment in land, gold to deposit in stocks, mutual funds, houses, pensions, etc. A recent study unveiled that more than half the Americans today hold stocks directly or through mutual funds. Thus asset bubbles are likely to create a larger impact.

Asset Bubble

In a layman’s term, it is an extended period of extreme overvaluation. Bubbles across various classes like the stocks, real estate, commodities, precious metals, etc. are known commonly. Bubbles are characterized by huge rise in the prices followed by a huge crash. It is seen that generally asset prices interact with the economic growth and inflation. In a growing economy, if the growth is accompanied by the rising asset prices, it surely leads to inflation. At such point of time, the manipulation or change in interest rate helps in controlling inflation but it certainly leads to cooling down of asset prices. On the contrary, similar principle applies when the economy is weak and asset prices are seen falling. Thus it is said that monetary policy works as an anti-dote for both the problems of inflation and asset prices.

The US Economy

Under this conventional approach we see certain limitations as was seen in the US economy during 1990. The US economy was performing well and inflation was under check, but the prices of assets were soaring high. As a result the conventional approach was not to raise the interest rates so as to restrain from tampering with the growth; and let  the asset prices increase. This is a serious short coming of the monetary policy as it cannot tackle the formation of asset bubble at all times, since its primary job is to control inflation and facilitate growth. Thus it would be a feasible solution to set up a special committee to track the asset prices at all times and provide recommendations on the valuation of the assets as and when required.

How to Deal with Asset Bubbles

It is recommended to establish an experienced group of financial experts to study the fundamental trends in stock  and  real estate prices and identify the long term valuation ranges. The committee must issue warning signals to the investors, lending institutions and other stakeholders whenever it is felt that the valuation of assets have moved outside the range. The primary job of the committee would not be to forecast the movement of the markets in future, but only to identify any misalignments in the present before they turn into major bubbles.

Given the level of corruption and political influence present in a country, it is important to ensure that the committee exist as an independent office within the central bank, so that it could help in resolving the conflict of interest for the bank between asset prices, inflation and growth. Also being the central bank, the availability of data is maximum with the authorities and thus they could easily house such committee within the banking environment.

The recommendation could be a major breakthrough in looking at the problem of asset bubbles and once established it will certainly help in lowering the frequency of  asset  bubbles, even if not completely eliminating their occurrence.