Who Stole the Punch?

As a follow/summary to the conversation I had with Professor Dickovick after class today, I'll first restate the main question: What should the role of central banks be with regard to interest rates following a bubble-burst? The natural thinking is that interest rates should be lowered, allowing for freer capital flows, which would stimulate the economy.

I proposed in class that after bubbles burst is not the time to lower rates, as that encourages banks to add more risks to their balance sheets, which is probably the reason you got into this whole mess anyway. However, after talking with Professor Dickovick, I realized that the reality is a bit more nuanced. Following a crisis, a credit crunch usually ensues. This freezes lending and investment, contracting the economy. Thus, even if the central bank lowers interest rates, people will be less likely to borrow money. However, as the economy improves, people are more willing to take on risk and borrow money. This is when the central bank needs to step in and raise rates. There is a saying that goes something like "a central bank needs to be the person that takes away the bowl of punch at the party," meaning that the bank needs to raise rates to avoid bubbles. This is to ensure sustainable growth, not a "bubble-cycle" of over-borrowing followed by a credit crunch.

Obviously, the above is much more nuanced in practice, but I think it's important this argument is made in whatever form.