View article

In recent times, equity and house prices in the Netherlands have soared. By late 1997 the AEX index of the Amsterdam Exchanges hovered around the 900 mark, having started the year at 634, reaching a maximum of 1011 on 7th August. House prices went up some 10% in 1996, a rate of increase that continued in the first half of 1997. This has led many to wonder whether in the early months of 1997 the Netherlands was subject to asset inflation. Asset inflation (or an asset bubble) occurs when the prices of financial assets rise above their underlying or intrinsic value.

This article addresses that question and discusses the economic risks and monetary policy consequences of asset inflation. Section 1 looks at the fundamentals that determine the intrinsic value of equities and houses. On the basis of this analytical approach, Section 2 examines whether the recent price rises in the Dutch financial markets are inflationary in nature or whether they can be attributed to improved fundamentals. Subsequently, Section 3 describes the economic risks of asset inflation for the Netherlands. As was shown dramatically by the 1929 Wall Street crash and the ensuing global depression, a bursting asset bubble may prompt a financial crisis and a collapse in economic activity. There is now consensus that central banks can mitigate the adverse effects of a bursting bubble by easing monetary policy. A more intriguing policy question, which is addressed in Section 4, is whether a central bank should wait until the bubble has actually burst, or whether it should play a more active role in preventing bubbles from arising in the first place.