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Asset price bubbles

October 17th, 2008

As the various asset price bubbles of the past decades or so inflated, and in some cases burst, there was vigorous debate about what, if anything should be done about them. The two main camps were those who advocated doing nothing, on the grounds that monetary policy should be focused solely on inflation, and those who thought that the settings of monetary policy should take asset prices into account. The first group won the debate at the time, at least as far as actual policy was concerned, with consequences we can all see. Most proponents of the do-nothing viewpoint have conceded defeat

In a paper in the (institutionalist) Journal of Economic Issues, which came out in 2006, Stephen Bell and I took a different view of the debate. We argued that there was little scope to respond to asset bubbles by changing the settings of existing monetary policy instruments, and that “any serious attempt to stabilize financial market outcomes must involve at least a partial reversal of deregulation.” Among other things, we pointed out the fact that given a presumption in favour of financial innovation, asset prices bubbles were inevitable, and that ‘In the absence of a severe failure in the financial system of the United States, it seems unlikely that ideas of a ‘new global financial architecture’ will ever be much more than ideas.’

You can read the full paper
Bell, S. and Quiggin, J. (2006), ‘Asset price instability and policy responses: The legacy of liberalization’, Journal of Economic Issues, XL(3), 629-49.

here

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  1. Uncle Milton
    October 17th, 2008 at 09:49 | #1

    This is very obviously the issue that central bankers around the world are going to have to deal with once the crisis is stabilised.

    But the answers are not obvious. Financial innovation is like cholesterol. There’s good and bad innovation. It’s obvious now that CDOs were bad innovation, but how obvious was it before the event? And the good and bad innovations are linked. So simple securitisation of housing loans is good (it allows more competition in the housing market) but on-selling the securities, CDO style, is bad. Are we then to conclude that all secondary markets are bad?

    As for “qualitative” regulations, what does that mean? Prior to liberalisation, the RBA used to call in senior bankers for a chat over a cup of tea and give them the gentle message that they should start lending less (or more). The bankers did what they were told. This was called qualitative guidance and known colloquially as “open mouth operations”, to distinguish it from open market operations. It worked in a heavy handed way but was totally opaque. Are we going to go back to those days?

    One institutional reform that should come out all of this is that financial regulation must come back directly to the central banks. When push comes to shove, it’s the central bank that has the balance sheet and can inject the liquidity into the financial system. Financial regulators like APRA have no money and so no ability to do anything in a crisis.

    APRA was created in the 1990s because deposit taking institutions and insurance companies, which had traditionally been very different animals and regulated differently, began to do both banking and insurance. So the insurance regulator and banking regulation part of the RBA were married (not entirely successfully, as the HIA episode showed).

    The logic was that insurance has nothing to do with RBA, so it shouldn’t be the insurance regulator. But as we’ve seen in the United States with AIG, failed insurance companies can threaten the financial system as surely as failed banks.

  2. jquiggin
    October 17th, 2008 at 11:49 | #2

    Our suggestion is that the burden of proof should be on innovators here. That is, if you want to securitize mortgages (for example) you need to show that you are not increasing systemic risk as a result.

    I agree with ending the split of prudential regulation and central banking.

  3. October 17th, 2008 at 12:08 | #3

    The problem with monetary policy is that consumer prices don’t offer a timely feedback signal and most of the array of other indicators of success or failure used internally to central banks are collectively too vague to provide clear accountability. Stability in consumer prices is a necessary but not sufficient indication of stability in the value of the national unit of account.

    Commodity spot prices don’t suffer any such lags. Which is why they were used for centuries.

    If open market operations were used instead to keep the currency stable with reference to gold (or a basket of commodities as per Keynes bancor) then interest rates would be more free to reflect, and signal, the market dynamics of credit markets.

    The gold standard when it was maintained (but not always during poorly considered transitions onto and off it) offered:-

    i) stable consumer prices
    ii) stable exchange rates
    iii) stable commodity prices
    iv) low rates of interest
    v) flexible rates of interest that reflected changes in the private sector supply of and demand for credit (although these were at times regulated)

    It wasn’t perfect but it was vastly better that what we have today. What it failed to deliver on occasion in terms of market stability in asset prices has in no way been improved on by the activist management of interest rates and in any case the cause of such instability can in most instances be explained by other factors.

    Targeting and fixing the price of credit is the problem with monetary policy today. Like all price fixing it creates shortages or gluts and impacts on the quality of the product. It creates the chaos in which the salesmen of socialism prosper, all the time moralising about the unreliabilty of capitalism.

  4. Ernestine Gross
    October 17th, 2008 at 12:39 | #4

    CODs (securitisation).

    Re #1. Uncle Milton, there seems to be little purpose in securitisation if the CODs cannot be sold.

    #2. John, what would you accept as suitable method of ‘proof’?

  5. Nick K
    October 17th, 2008 at 13:14 | #5

    Terje at 3, I agree that targetting and fixing the price of credit is a big part of the problem. Especially in the US, where the Reserve kept interest rates too low for too long.

    The correct level of interest rates in any economy should roughly equal inflation plus risk. When you have central banks arbitrarily trying to fix interest rates below what the market conditions would deliver, it cannot be achieved without creating damaging side effects.

    The notion that interest rates can be centrally fixed in order to achieve any given policy outcome (such as reducing inflation or increasing growth) without regard for the conditions in the real economy and their impact on market rates (such as the supply and demand for credit, or the rate of inflation) should be seriously questioned.

  6. stockingrate
    October 17th, 2008 at 13:57 | #6

    Does the RBA have a defacto interest rate policy in favour of asset speculation? When asset prices go up there is no strong lean into the trend, when asset prices fall -as we see now- interest rates are cut.

    Does tax policy in Australia favour asset speculation over saving from wages? Especially does tax policy favour speculation in real estate, which being a large asset class creates especially damaging bubbles? A tax policy of zero capital gains on the home, and 50% discount on other capital gains encourages speculation over saving from labour income to earn interest income and store wealth. Super tax concessions ameliorate this somewhat.

  7. Nick K
    October 17th, 2008 at 16:36 | #7

    stockingrate, tax policy in Australia does encourage asset bubbles, particularly in real estate.

    Policies like negative gearing as well as the CGT exemption for primary residences have the effect of encouraging people to increase the value of real estate they own instead of investing elsewhere in the economy in things like shares or new businesses.

    Increased real estate values don’t generate much benefit for the rest of the economy, such as increased employment. Instead, they actually do more harm by making housing less affordable for others.

  8. Smiley
    October 17th, 2008 at 19:13 | #8

    While the recession of the early 90′s was probably regrettable, it did slow down the sort of speculation in property that has manifested itself in the last boom.

    I agree with the general comment that interest rates are a blunt tool, but don’t banks keep a record of the type of businesses or investments for which the loans are made. Couldn’t this information be used to set different interest rates for different aspects of the economy? If a boom shows up in one sector of the economy interest rates rise for that sector. Likewise if there is a slump, interest rates fall.

  9. SJ
    October 17th, 2008 at 20:08 | #9

    EG, a COD is a fish. If you can’t sell it, you could just cook it and eat it. A CDO is something else. ;)

  10. Ernestine Gross
    October 17th, 2008 at 20:51 | #10

    SJ, no wonder I didn’t get a reply. But a good laugh is worth something, too. I’ll resubmit shortly. Thanks for the editorial services.

  11. Smiley
    October 17th, 2008 at 21:56 | #11

    Targeting and fixing the price of credit is the problem with monetary policy today.

    Are you saying that banks should set interest rates independently? How can a bank make informed decisions about any one sector of the economy when they don’t know what the other banks are doing in that sector? It seems to me that it is the natural role of the Reserve Bank to make such assessments.

  12. TerjeP
    October 18th, 2008 at 04:45 | #12

    Are you saying that banks should set interest rates independently?

    Yes. I am saying that banks should set interest rates based on demand just like any other business. That is essentially what they do at the moment except that central banks distort supply and demand through open market operations and interest rate targeting (ie artificially increasing supply or demand to achieve a particular price of credit in the market place). The central bank should continue to do open market operations but they should stop targeting interest rates and merely stabilise the real value of the currency using a more appropriate price signal (I’ve nominated gold which is what Robert Mundell would nominate but you could nominate a commodity basket instead which is what Keynes nominated when he proposed the Bancor). The central bank would then still be a settlement house and a monetary authority but a far less noxious one.

    Whilst I can understand some arguments for modest regulation of Banks they most definitely do not need central planning. They need a clean price signal.

    How can a bank make informed decisions about any one sector of the economy when they don’t know what the other banks are doing in that sector? It seems to me that it is the natural role of the Reserve Bank to make such assessments.

    With a clean price signal you don’t generally need to know that much about the specific details of what your competitors are doing. The central bank just adds noise to the price signal anyway. And in terms of acting as a news bureau I suspect that most banks rely more on the Financial Times than on the central bank.

  13. Michael of Summer Hill
    October 18th, 2008 at 11:29 | #13

    John, the problem with consumers is that they do not have perfect knowledge of the state of play within markets and succumb to ‘market pressures’ from financial institutions and real estate agents to buy buy buy as was the case in USA before the bubble burst.

  14. October 18th, 2008 at 12:04 | #14

    That sounds a bit like the problem with voters.

  15. October 18th, 2008 at 13:13 | #15

    Terje,
    Just a couple of thoughts. I would see using commodities as a proxy for value as possibly appropriate when a large part of the value input into the goods and services chain as being composed of commodities – or things closely correlated with commodities. I would think this is less true today than it was a century or so ago – the input value of labour and the other factors is so much higher today than it was then. Therefore, I am not satisfied that using commodities (even a broad basket) is necessarily a suitable “anchor” for currency.
    .
    Michael,
    I am also not satisfied with the “consumers are stupid sheep” argument that you seem to be using a mild formulation of. People respond to incentives, even if sometimes slowly and imperfectly. Indeed, it is that response, slow and imperfect as it is that makes me very wary of government action to create incentives. Their workings tend to be unpredictable at best.

  16. Nick K
    October 18th, 2008 at 16:52 | #16

    #8 Smiley, banks often charge higher interest rates for borrowing that is higher risk or unsecured.

    As per your suggestion that banks should charge different interest rates for different sectors of the economy, I can see a few problems with that. There would be plenty of opportunities for people to work the system by applying for cheap credit and then relending it at a higher price.

    The nature of credit is that the base interest rate has to be the same throughout an economy.

  17. Smiley
    October 18th, 2008 at 17:22 | #17

    Of course it’s pointless trying to discuss what the real value of assets should be and what measures should be in place to keep them in check when the government is actively seeking to keep the values inflated through middle class welfare such as the FHOG and by artifically keeping demand high via high immigration.

    It’s a self defeating policy, because young couples who have bought property cannot afford to have children, and as asset values come down in other parts of the world, Australia will be seen unfavourably by potential immigrants. Except our currency may keep droping as our government tries to keep property prices inflated.

    Of course the very same people who will take advantage of the FHOG will complain as petrol prices increase because the value of the dollar is dropping.

    As you can see I trust neither the government nor the consumer/voter. It’s not that they’re completely stupid, it’s that they do things for what they perceive is in their short term self-interest. There’s no consideration for how thing might be in 5 or 10 years time.

  18. Smiley
    October 18th, 2008 at 17:41 | #18

    There would be plenty of opportunities for people to work the system by applying for cheap credit and then relending it at a higher price.

    Who are those people? The banking system is regulated so not everyone can become a lender. When I apply for a loan at a bank I have to tell them exactly what I intend to use the funds for, and it would be fraudulent to use the funds for something else. I’m no banker but that’s probably how it works now.

    Why not require banks to supply all that information to the RBA, who can determine if there is a boom or a slump developing.

  19. October 18th, 2008 at 18:05 | #19

    Smiley,
    Small correction – anyone can become a lender. It is deposit taking that that is the regulated industry.

  20. Smiley
    October 18th, 2008 at 18:45 | #20

    Thanks Andrew. I still don’t see why it’s a problem, becuase non-bank lenders have to remain competitive, and need to maximise the profit for the funds that they have for lending. They would want to ensure that their customers are not using arbitrage and would require as much proof as a bank.

  21. TerjeP
    October 18th, 2008 at 20:09 | #21

    Just a couple of thoughts. I would see using commodities as a proxy for value as possibly appropriate when a large part of the value input into the goods and services chain as being composed of commodities – or things closely correlated with commodities. I would think this is less true today than it was a century or so ago – the input value of labour and the other factors is so much higher today than it was then.

    I don’t agree that commodities wouldn’t work as a proxy for value but I’d be interested in the alternatives you might propose. In order to make it a direct target for open market operations it needs to be something for which there is a spot market. In order for it to be a leading indicator of inflation rather than a lagging indicator of inflation it likewise needs to be a price that is responsive to monetary factors. Commodites fit the bill on both counts however perhaps you can suggest something else.

    Even 100 years ago when the monetary policy target was effectively gold the amount of gold that was used in the supply chain to produce goods and services generally would have been next to zero. You can’t eat or readily burn gold so it offers no energy value and you can’t build many things out of it that have significant utility beyond jewellery. It probably has more industrial application today than it did 100 years ago via the computer industry. As such any argument that it was suitable 100 years ago but not today because of supply chain composition factors does not seem very valid to me.

    The predominant utility of gold has always been decorative and monetary. When the Bretton Woods scheme ended gold was supposed to loose it’s monetary value and the decline in utility was supposed to see it’s value fall also. It never happened. In fact the end of the Bretton Woods scheme increased the monetary utility of gold. Not withstanding the fact that private ownership of gold bullion was still illegal at the time in parts of the world (eg USA until 1975, China until 2005).

  22. TerjeP
    October 18th, 2008 at 20:11 | #22

    p.s. Which is why in the early James Bond movies all the bad guys who weren’t drug smugglers were instead gold smugglers.

  23. Smiley
    October 18th, 2008 at 21:04 | #23

    In order for it to be a leading indicator of inflation rather than a lagging indicator of inflation it likewise needs to be a price that is responsive to monetary factors. Commodites fit the bill on both counts however perhaps you can suggest something else.

    There was a lot of inflation in asset values in Australia between 2000 and 2003. I’m only aware of the price of gold in $US over that period. Is there a graph or some data that shows what happened to commodities in that period? Does it support your statement?

  24. TerjeP
    October 18th, 2008 at 23:50 | #24
  25. Katz
    October 19th, 2008 at 07:19 | #25

    AR

    Michael,
    I am also not satisfied with the “consumers are stupid sheep� argument that you seem to be using a mild formulation of. People respond to incentives, even if sometimes slowly and imperfectly. Indeed, it is that response, slow and imperfect as it is that makes me very wary of government action to create incentives. Their workings tend to be unpredictable at best.

    The redoubtable Anna Schwatz, still spry at 92, said this:

    But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it’s so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses.

    To a sheep it seems quite rational to walk sedately with the rest of the flock to the slaughter. Sheep have a herd instinct that farmers and slaughtermen have been profiting from ever since the domestication of animals, which was a very long time ago.

    Bankers, like farmers and slaughtermen, offer their clients all sorts of inducements not to change their behaviour. This herd behaviour makes the lives of slaughtermen and bankers very easy.

    Yet human beings aren’t sheep. They have history books. It is the choice of the borrower to decide whether or not “it is going to be different this time”. And sometimes they are different.

    Some things do change. The institution of the non-recourse mortgage in the US reduced enormously the apparent risk of over-extending to take on a mortgage. Borrowers did react quite rationally to that free kick against the creditor by borrowing to the hilt.

    Banks evaded capital adequacy limitations by securitising their loan books. It was the responsibility of those parties buying this risk to price it properly. It is now clar that the biggest mug in this game of pass the parcel got that pricing of risk horribly, horribly wrong.

    If these mugs didn’t exist, there would not have been an enormous asset bubble in US housing because the banks would not have been able to offload their risks so cheaply.

    When you question self-destructive impulses, perhaps you are looking at the wrong folks. Home-buyers and bankers successfully minimised their risks in the first instance.

    It was the risk-takers who acted irrationally in this case.

  26. Joseph Clark
    October 19th, 2008 at 11:40 | #26

    Katz,
    That’s a very good point. I’d also add that everybody who didn’t sell credit (almost all of us) was just as irrational as the risk-takers who bought it.

  27. October 19th, 2008 at 15:59 | #27

    isn’t it possible that the management of the economy is actually much simpler than cosmology or high energy physics?

    can it it be that if commercial activity was reported quickly to a central computer, the nation could be run effectively?

    is the latest collapse of the figleaf of rational and responsible management enough to stimulate academia to design and promote an actual financial system that works?

    no. discussion remains centered around the aerodynamic qualities of politically correct angels in transition patterns over the (pin)heads of our current political masters.

    fortunately,don horne thought he was being satirical when he styled this wide brown land “lucky”. if he’d realized it was the truth, he would have had to find something punchier, “the kingdom of the blind to the threadbare evanescence of the emperor’s official deputy’s financial newish clothes” comes to mind.

  28. Katz
    October 19th, 2008 at 17:05 | #28

    can it it be that if commercial activity was reported quickly to a central computer, the nation could be run effectively?

    That may work for as long as folks are prepared to stay within the algorithms encompassed by the computer. This would be a strictly closed system with a finite set of rules and a finite number of allowed outcomes, like draughts. In fact, an economy is more like poker, which isn’t a closed system and which allows potentially an infinite number of winning (and losing) outcomes.

    So long as there is incentive to do so, any system, no matter how tightly structured it is, can in the real world be gamed.

    Paradoxically, it might be argued, the tighter the system, the bigger the bubble and the worse the crash, when it finally arrives, as it will.

  29. Michael of Summer Hill
    October 20th, 2008 at 09:41 | #29

    John, if I may reply to Andrew Reynolds by saying if consumers had perfect knowledge of markets then they would not have been unwittingly fleeced by predatory mortgage lenders as was the case in the USA before the real estate bubble burst.

  30. SJ
    October 20th, 2008 at 10:26 | #30

    From today’s AFR – Alex Masterley discusses CODs

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