Alan Greenspan was right to raise the question “How do we know when ‘irrational exuberance’ has unduly escalated stock prices?”, which is what he actually said in 1996. But he was wrong to conclude subsequently that monetary policy should ignore asset prices (or even that it should take asset prices into account only to the extent that they contain information about future inflation, as the Inflation Targeters would have it). More specifically,
(1) Identifying in real time that we were in a stock market bubble by 2000 and a real estate bubble by 2006 was not in fact harder than the Fed’s usual job, forecasting inflation 18 months ahead;
(2) Central bankers do have tools that can often prick bubbles; and
(3) The “Greenspan put” policy of mopping up the damage only after run-ups abruptly end probably contributed to the magnitude of the bubbles ex ante, while yet being insufficient ex post to prevent the crisis from becoming the worst recession since the 1930s. All three points run contrary to what was conventional wisdom among monetary economists and central bankers a mere two years ago.
The Queen of England during the summer asked economists why no one had predicted the credit crunch and recession.Paul Krugman points out that, inasmuch as economists can almost never predict the timing of recessions (and don’t claim to be able to), the real questions are worse. The real questions are, rather how macroeconomists (most) could have gotten it so wrong as to believe that:
(i) a severe recession was not even looming ahead as a potential danger, and
(ii) a breakdown of many of the world’s most liquid financial markets, in New York and London, was impossible to imagine.