The Market Forest Fire Analogy

Fire fighters often complain about the downside of fire prevention. By preventing small fires, the fuel for large ones continues to accumulate and dry out. Then when conditions are right – hot days and high winds – conflagrations can occur. This “boom and bust” fire cycle has been a continued problem in my home state of California.

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which markets are closed

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The interesting question is, does the same logic apply to central banks and asset price busts? For instance, in the years leading up to 2000 and 2008, central bank policy was loose and asset prices rose sharply. (Tech stocks in the years before 2000 and housing prices in the years before 2008.) John Taylor, currently one of the leading candidates for Chairmanship of the Fed, argues that had the Fed followed his rule and tightened in 2004/2005, the housing collapse and associated great recession could have be alleviated or avoided.

This leads to the question of whether the Fed should target asset prices. The standard answer has been no. The Fed should target inflation in consumer prices, but not asset prices. But in recent times, it has been booms and busts in asset prices that have caused most of the economic damage. It is not surprising, therefore, that a debate has arisen in academic circles over the targeting of asset prices. Given my view expressed in this blog that asset prices are again approaching unsustainable levels, driven in my by investors reaching for yield and taking on more leverage, I find the argument that the Fed should pay attention to asset prices increasingly convincing.

Article by Bradford Cornell's Economic Blog

About the Author

Brad Cornell
Bradford Cornell is a emeritus Professor of Financial Economics at the Anderson School of Management at UCLA. Prof. Cornell has taught courses on Applied Corporate Finance, Investment Banking, and Corporate Valuation. Professor Cornell received his Masters degree in Statistics and his PhD in Financial Economics from Stanford University. In his academic capacity, Professor Cornell has published more than 125 articles on a wide variety of topics in applied finance, particularly empirical analysis of asset pricing models. He is also the author of Corporate Valuation: Tools for Effective Appraisal and Decision Making, published by Business One Irwin, The Equity Risk Premium and the Long-Run Future of the Stock Market, published by John Wiley and Conceptual Foundations of Investing published by John Wiley. He is a past Director and Vice-President of the Western Finance Association and a past Director of the American Finance Association. As a consultant, Professor Cornell has provided testimony and expert analysis in some of the largest and most widely publicized finance related cases in the United States. Among his clients are: AT&T, Berkshire Hathaway, Bristol-Myers, Citigroup, Credit Suisse, General Motors, Goldman Sachs, Merck, Microsoft, Morgan Stanley, Orange County CA, Price Waterhouse, Verizon, Walt Disney and various agencies of the United States Government. Professor Cornell is also a senior advisor to Rayliant Global Investors and to the Cornell Capital Group. In both capacities, he provides advice on fundamental investment valuation. In his free time Prof. Cornell enjoys cycling and golf.