Caballero view: bubbles are inevitable and possibly long-lasting in economy facing asset shortages •  there has been significant increase in global savings relative to investments (you can merge Bernanke global savings glut with IMF global investment drought hypotheses here)  •  this excess saving is chasing too few available financial assets, which leads to very high valuations (rising equity indices, low long-term rates, low corporate and EM spreads etc.) •  problem lies in the underdevelopment of financial markets in emerging economies, which due to poor governance and property rights do not have enough good quality collateral to back debt obligations. These economies have also many other macroeconomic and microeconomic deficiencies leading to asset shortages and reduction of value of existing assets such as: weak bankruptcy procedures, chronic macroeconomic volatility and sheer appropriation risk. 15  http://www.rybinski.eu/wp-content/uploads/gi_en_rybinski_panel_discussion_1_09_2006.pdf  16  Calvo G. and Talvi E. (2006) “The Resolution of Global Imbalances: Soft Landing in the North, Sudden Stop in Emerging Markets?”, CERES, Documentos de Trabajo. 17  Caballero R. (2006) “On the Macroeconomics of Asset Shortages”, NBER Working Paper No. 12753, December 2006. 18  Faruqee H., Laxton D., Muir D., Pesenti P.(2006) “Would Protectionism Defuse Global Imbalances and Spur Economic Activity? A Scenario Analysis”, NBEW Working Paper 12704, November 2006.
In this environment, some have questioned the ability of our supervisory and regulatory tools to adequately address potential financial instability risks. They argue that a broad tightening of interest rate policy might be more effective in catching incipient risks that might fall through the cracks. It is certainly true that higher interest rates would permeate the entire financial system. But this is just another way of saying that raising interest rates is a blunt tool. Higher interest rates would reduce risk-taking where it is excessive; but they also would result in a pullback in economic activity in sectors where risk-taking might already be overly restrained. That’s how a blunt tool works. If you believe that financial stability can only be achieved through higher interest rates – interest rates that would do immediate damage to meeting our dual mandate goals at a time when unemployment is still unacceptably high – then we ought to at least ask ourselves if the financial system has become too big and too complex. BIS central bankers’ speeches  5  Think about how problematic the cost-benefit calculus becomes if the only way we can achieve financial stability is to raise interest rates above the level where the forces of demand and supply in the real economy put them. The possible benefit of such a restrictive rate move would be to reduce risks that might be forming in the nooks and crannies of a highly complex financial system.