Central banks have an aversion to bailing out speculators when asset bubbles burst, but ultimately, as custodians of the financial system, they have to do exactly that. Their actions are justified by the goal of protecting the economy from the bursting of bubbles; while their intention may be different, the result is the same: speculators, careless investors, and banks are bailed out. The authors of this new Policy Note say that a far better approach is for central banks to widen their scope and target the net wealth of the personal sector. Using interest rates in both the upswing and the downswing of a (business) cycle would avoid moral hazard. A net wealth target would not impede the free functioning of the financial system, as it deals with the economic consequences of the rise and fall of asset prices rather than with asset prices (equities or houses) per se. It would also help to control liquidity and avoid future crises. The current crisis has its roots in the excessive liquidity that, beginning in the mid 1990s, financed a series of asset bubbles. This liquidity was the outcome of “bad” financial engineering that spilled over to other banks and to the personal sector through securitization, in conjunction with overly accommodating monetary policy. Hence, targeting net wealth would also help control liquidity, the authors say, without interfering with the financial engineering of banks.

Elias Karakitsos

Philip Arestis

English

Research Papers in Economics

The Levy Economics Institute of Bard College
Policy Note
2009 / 2
Senior Scholar philip arestis is university director of research at the Cambridge Centre for Economic and Public Policy, Department of
Land Economy, University of Cambridge.
elias karakitsosis director and CIO of Guildhall Asset Management and an associate member of the Centre for Economic and Public Policy.
The Levy Economics Institute is publishing this research with the conviction that it is a constructive and positive contribution to the discus-
sion on relevant policy issues. Neither the Institute’s Board of Governors nor its advisers necessarily endorse any proposal made by the authors.
Copyright © 2009 The Levy Economics Institute
WHAT ROLE FOR CENTRAL BANKS IN
VIEW OF THE CURRENT CRISIS?
philip arestis and elias karakitsos
Introduction
Central banks have an aversion to bailing out speculators when asset bubbles burst, but ultimately,
as custodians of the financial system, they have to do exactly that. Their actions are justified by the
goal of protecting the economy from the bursting of bubbles. While their intention may be differ-
ent, the result is the same: speculators, careless investors, and banks are bailed out. A far better
approach is for central banks to widen their scope and target the net wealth of the personal sec-
tor. Using interest rates in both the upswing and the downswing of a (business) cycle would avoid
moral hazard (Arestis and Karakitsos 2009b). 
A net wealth target would not impede the free functioning of the financial system, as it deals with
the economic consequences of the rise and fall of asset prices rather than asset prices (equities or
houses) per se. Thus, it is not a target, say, on the S&P 500, on house prices, or on their rates of growth.
Although a boost in house or equity prices will increase gross wealth, this is not a one-to-one 
relationship. First, the volume of houses may increase proportionately less than the increase in gross
wealth, or the stock market capitalization may change. Second, if an increase in gross wealth is
matched by a corresponding increase in debt or in disposable income, net wealth will not increase. In
the last two years of the housing bubble, for example, gross wealth increased but net wealth decreased.
A wealth target would also help to control liquidity and avoid future crises. The woes of the current
crisis have their roots in excessive liquidity that financed a number of bubbles in the last 10 years.
This liquidity is the outcome of “bad” financial engineering that spilled over to other banks and tothe personal sector through securitization, and an overly accom-
modating monetary policy (Arestis 2007; Arestis and Karakitsos
2009a). Hence, targeting net wealth will also help control liquid-
ity, without interfering with the financial engineering of banks.
This policy note provides the background for and details of
our new policy initiative, which we suggest is of paramount
importance in view of the current crisis and new economic
realities. 
Targeting Net Wealth
One can sympathize with those who argue that central banks
should not rescue speculators, careless investors, or banks when
bubbles burst because they encouraged the sale (purchase) of
assets in the upswing of the economic cycle. A rescue encour-
ages one-way bets on future bubbles, as investors expect central
banks to bail them out in an economic downswing. Many com-
mentators during the current crisis have advocated policies that
avoid moral hazard. As custodians of the financial system, cen-
tral bankers share this concern, but they must act when markets
are dysfunctional. In the current crisis they have injected tem-
porary liquidity and provided direct loans to banks in trouble.
In the beginning (of the crisis) they refrained from lowering
interest rates that would make their temporary liquidity injec-
tions permanent, thereby avoiding moral hazard issues. As the
crisis deepened, however, the Federal Reserve (Fed), the Bank of
England (BoE), and the European Central Bank (ECB), although
very reluctantly, made temporary liquidity permanent by cut-
ting interest rates. This action raises the issue of whether the
central banks are too monolithic by merely concentrating on
inflation (an argument propounded in Arestis and Karakitsos
2004 and 2009a). Edward Leamer (2007) makes the point well
when he argues that the Fed’s focus on issues other than hous-
ing led to an overheated housing market whose unravelling
threatens to plunge the U.S. economy into recession (which has
come to pass). The experience of many countries as well as the
United States shows that successful control of CPI-inflation
does not guarantee control of asset price inflation. The thrust of
the argument is succinctly summarized by Claudio Borio (2008),
who labels it a “paradox of credibility,” implying that the more a
central bank succeeds in keeping prices stable, the more likely that
asset bubbles will be the first signal of an overheating economy.1
The standard argument against asset price targeting is that it
interferes with not only the free functioning of financial markets
but also the economy as a whole. Moreover, it is considered to
be outside the realm of central banks because it results from
“irrational exuberance” or else reflects market forces. According
to Alan Greenspan (2005), asset price targeting would require
the authorities to outperform market participants. Central
bankers would rather deal with the consequences of bubbles
that burst by minimizing the damage to the real economy.
Greenspan’s success after the dot-com bubble burst in 2001
gave some credence to this approach, which has been adopted
by the four major central banks (the Fed, BoE, ECB, and Bank
of Japan). But the recent housing bubble could be viewed as the
result of Greenspan’s “successful” policies at the turn of the 21st
century that countered the threat of a 1930s-style depression
after the dot-com collapse. 
The way to avoid these problems is to monitor and target
the implications of asset prices for consumer spending patterns.
A primary candidate for this purpose is the net wealth of the
private sector. Net wealth is defined as (financial and tangible)
assets less personal sector liabilities, including mortgage debt
and consumer credit. The ratio of net wealth to disposable
income fluctuates widely in the short term but there is no trend
in the long term because to imply otherwise would mean inter-
generational changes in savings habits. Net wealth is an ideal
variable to monitor (and control) bubbles because it is at the
heart of the transmission mechanism between asset prices and
debt, and consumption. 
Since the end of World War II, average net wealth in the
United States has been approximately five times annual dispos-
able income. The peak of the recent equity bubble became
transparent when net wealth hit a high of 6.2 times annual dis-
posable income. The peak ratio subsided when equity prices
fell, but it revived with the emergence of a new (housing) bub-
ble. Thus, the Fed should maintain a target ratio of net wealth
to disposable income in the range of, say, 4.3 to 5.3, similar to
its implicit target of 1 to 2 percent for core PCE (personal con-
sumption expenditure) inflation. The target range could be
revised to account for demographics or to anchor expectations of
asset price inflation. Furthermore, monetary policy should be
tightened or relaxed to maintain this particular threshold. This
action would not only allow asset price booms but it would also
prevent bubbles, and their huge adverse economic consequences. 
This approach would also help to regulate financial engineer-
ing. Securitization implies a transfer of risk from banks to the per-
sonal sector, making banks more willing to promote both lending
Policy Note, 2009/2 2The Levy Economics Institute of Bard College 3
and the sale of asset-backed securities to the personal sector.
Financial engineering enabled the U.S. housing market bubble,
and its complexity means that central banks would find it difficult
to measure, monitor, and control total liquidity in the economy. A
wealth target, however, would mitigate the consequences of liq-
uidity and not impede the financial engineering of banks. 
The Merits and Perils of Wealth Targeting
If monetary policy is guided solely by inflation, then a central
bank is unlikely to deal adequately with a credit crisis because
the volatility of the output gap is greater than the volatility of
inflation in an asset-led business cycle. When credit expands
and asset prices soar in a cycle upswing, inflation remains sub-
dued for two reasons. First, potential output increases, thus
dampening the positive output gap and containing inflationary
pressures. Second, cyclical productivity improvements (which
appeared to be structural in the United States in the late 1990s)
reduce unit labor costs and also put a lid on inflation. But the
expansion of credit and soaring asset prices increase output dis-
proportionately compared to the default demand-led business
cycle. Therefore, a central bank is well advised to have two tar-
gets in an asset-led business cycle—inflation and the output
gap—in order to successfully deal with a credit crisis and the
consequences of a bursting asset bubble (and despite the fact
that its only instrument is interest rates). 
In a highly leveraged economy like the United States, how-
ever, even these two targets would be inadequate to deal with an
economic crisis; increasing leverage means that monetary pol-
icy would likely lead to a prolonged crisis and possibly to insta-
bility, because the economy responds to changes in interest
rates and profitability at different rates. The rationale is as fol-
lows. Net wealth depends on interest rates, which affect house
prices and equities, and on profitability, which influences aggre-
gate demand and equities. Both of these items of net wealth are
related to the degree of leverage, and the higher the leverage, the
higher the items’ sensitivity to interest rate changes. As an exam-
ple, consider the implications of structured investment vehicles
(SIVs). SIVs created a shadow banking system outside the con-
trol and regulation of authorities, who significantly expanded
liquidity (Arestis and Karakitsos 2009b). SIV activities were
financed through the London money market, and their prof-
itability depended on the yield curve (the relationship between
short- and long-term interest rates). They were very sensitive to
interest rates, and collapsed when the yield curve became
slightly inverted by a small rise in money market rates above
mortgage rates. Since the asset-backed securities issued by SIVs
were held by the personal sector, household net wealth also
became very sensitive to changes in interest rates. 
Thus, central banks face a much more difficult problem in
stabilizing a leveraged economy. The credit crisis is prolonged
by the heightened response of net wealth to interest rates and
profitability, as central banks are forced to move interest rates
up and down within target ranges. This response makes the sys-
tem unstable, and an economy never converges to its initial
steady state following a (temporary) credit crisis. Oscillating
interest rates from the central bank ultimately cause instability
because the economy responds to profitability faster than to
interest rates, which are a stylized fact of the real world. Given
that the real profit rate plays an important and more immediate
role than interest rates in stabilizing an economy, and given that
the interest rate influences the real profit rate (which is respond-
ing to economic developments), it is not unreasonable that the
actions of the central bank may destabilize a highly leveraged
economy. Therefore, the response of monetary policy to infla-
tion and the output gap in a highly leveraged economy will
likely be inadequate in dealing with a credit crisis. Mild wealth
targeting would prove beneficial in this environment.
A wealth target would reduce the impact of widening credit
spreads on net wealth, so there would be a milder recession in
light of smaller declines in profits and in interest rate cuts by
central banks, leading to lower costs in terms of lost output and
enabling the economy to weather the bursting of a bubble. A mild
wealth targeting agenda at central banks is therefore beneficial in
stabilizing an economy around potential output during an
asset-led business cycle. 
We caution that overly zealous enthusiasm for wealth tar-
geting might cause instability and lead to a deeper recession
than that associated with mild wealth targeting, despite initially
arresting the fall in net wealth. Large swings in interest rates,
combined with lags in the effects of monetary policy and the
quick response of demand and wealth to profitability, would
create volatility, destabilizing the economy and leading to a pro-
longed recession. Mild wealth targeting, therefore, is preferable
to either no or excessive wealth targeting. In the real world,
profitability adjusts faster than interest rates, and economies
respond faster to changes in profitability than to changes in
interest rates.Conclusion
The sole reliance of monetary policy on inflation is highly
unlikely to deal with the current global credit crisis in an asset-
led business cycle because the volatility of the output gap is
greater than the volatility of inflation. Adding the output gap to
a central bank’s target list would enhance its ability to stabilize
an economy around potential output. In a highly leveraged
economy, however, these two targets would do little to free up
credit, because the economy responds faster to profitability
than to interest rates. Mild, but not excessive, wealth targeting
would reduce the lost output in a credit crisis as well as the
amplitude of the business cycle.
Note
1.  “Paradoxically, these endogenous responses to credible
monetary policy increase the probability that latent infla-
tion pressures manifest themselves in the development of
imbalances in the financial system, rather than immediate
upward pressure on higher goods and services price infla-
tion” (Borio and Lowe 2002, p. 22).
References
Arestis, P. 2007. “What Is the New Consensus in
Macroeconomics?” in P. Arestis, ed. Is There a New
Consensus in Macroeconomics? Houndmills, Basingstoke:
Palgrave Macmillan.
Arestis, P., and E. Karakitsos. 2004. The Post-Bubble US
Economy: Implications for Financial Markets. Houndmills,
Basingstoke: Palgrave Macmillan.
———. 2009a. “Unemployment and the Natural Interest Rate
in a Neo-Wicksellian Model.” In P. Arestis and J.
McCombie, eds., Unemployment: Past and Present.
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———. 2009b. “Subprime Mortgage Market and the Current
Financial Crisis.” CCEPP WP08–09. Cambridge Centre
for Economic and Public Policy, Department of Land
Economy, University of Cambridge. February.
Forthcoming in P. Arestis, P. Mooslechner, and K. Wagner,
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States—Any Solutions Available? Houndmills, Basingstoke:
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Borio, C. 2008. “The Financial Turmoil of 2007–? A
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Working Paper No. 251. Basel: Bank for International
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Borio, C., and P. Lowe. 2002. “Asset Prices, Financial and
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Greenspan, A. 2005. “Reflections on Central Banking.” Paper
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Recent Levy Institute Publications
POLICY NOTES
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philip arestisandelias karakitsos
2009/2
Obama’s Job Creation Promise: A Modest Proposal to
Guarantee That He Meets and Exceeds Expectations
pavlina r. tcherneva
2009/1
Time to Bail Out: Alternatives to the Bush-Paulson Plan
dimitri b. papadimitriou and l. randall wray
2008/6
Will the Paulson Bailout Produce the Basis for Another
Minsky Moment?
jan kregel
2008/5
A Simple Proposal to Resolve the Disruption of Counterparty
Risk in Short-Term Credit Markets
jan kregel
2008/4
Policy Note, 2009/2 4

Housing Is the Business Cycle.” Paper presented at “The Housing Market,“ a symposium sponsored by the Federal Reserve Bank of Kansas City,

Reflections on Central Banking.” Paper presented at “The Greenspan Era: Lessons for the Future,” a symposium sponsored by the Federal Reserve Bank of Kansas City,

Subprime Mortgage Market and the Current Financial Crisis.” CCEPP WP08–09. Cambridge Centre for Economic and Public Policy,

The Financial Turmoil of 2007–? A Preliminary Assessment and Some Policy Considerations.” Working Paper No. 251. Basel: Bank for International Settlements.

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