As a result of exaggerated euphoria, a basis for risks that may lead to future instability can be created even before the threat of inflation becomes more visible. In the event of rapidly rising asset prices, with the associated risk of financial instability, a central bank should therefore keep a watchful eye on credit expansion in the economy. Under such circumstances the central bank may need to intervene in the interests of financial stability. In my opinion, interest rate adjustments should certainly not be ruled out if they are judged to be effective. In other contexts I have mentioned the desirability of such a “flexible inflation targeting policy” and believe that support for action of this type is to be found in current legislation. The recent share price bubble was not accompanied by any undue expansion of credit. This was no doubt partly because the Swedish bank crisis is still so fresh in people’s minds and banks here have made the process of providing credit much more rigorous. The IT and telecom bubble in the 1990s So much for financial bubbles in general and what general economic policy can do. There is, however, more to learn from WorldCom, Enron and the whole of the IT and telecom bubble. American studies suggest that the new technology which enabled people to do their own share trading on the Internet attracted many people who were unfamiliar with saving in shares.
Perhaps a society has to undergo a learning process on a broad front so that earlier mistakes yield new insights. Economic policy decision-makers like myself are, of course, no exception here. But as financial turbulence does not inevitably lead to a serious crisis in the real economy, we need to ask why it is that in certain cases output and employment do suffer severe setbacks and the attendant deflation. Much will have been gained if we can learn to tell whether or not an extensive share price fall, for example, besides being troublesome enough for many people, is likely to result in a situation with general deflation, rapidly falling output and rising unemployment. An answer to that question was suggested in the summer of 1999 by the Federal Reserve chairman, Alan Greenspan: While bubbles that burst are scarcely benign, the consequences need not be catastrophic for the economy. The bursting of the Japanese bubble a decade ago did not lead immediately to sharp contractions in output or a significant rise in unemployment. Arguably, it was the subsequent failure to address the damage to the financial system in a timely manner that caused Japan’s current economic problems. Likewise, while the stock market crash of 1929 was destabilising, most analysts attribute the Great Depression to the ensuing failures of Policy. Most things indicate that when banks run into trouble on account of financial turbulence, the supply of credit may dry up and the payment system cease to function.