Financial Crises and the Prospects for Recession1

Abstract

Crises have a common shape but not always common consequences, as Barrell and Davis (2005) discuss. Asset bubbles are associated with the run-up to most crises and regulators should respond, taking an asset bubble as a signal of a need for precautionary action. It is easy to say that fundamentals have changed an asset market, and hard to spot a bubble. It is also common to suggest that interest rate policy should be set to constrain bubbles such as those in housing markets in recent years. Not only is it difficult for the central bank to use interest rates to constrain a bubble, it is also inappropriate if inflation is under control. It is for the financial market regulator, which may or may not be in the central bank, to respond to the bubble and strengthen its precautionary measures designed to raise lending standards.