Archive for June 29th, 2007

Financial Bubbles

June 29, 2007

Before I begin, I have a serious suggestion for all those who read my blog and have an interest in economics and finance. Make sure, you read all the speeches of Ben Bernanke. He is simply superb and explains all the topics with rich references and literature survey. I may go overboard, but one Bernanke Speech a day keeps the fat books/papers away!! 

Now with the main topic. Generally, analysts are divided in two groups. First says, times are good and asset prices/sectors/economy would go up and Second says, not all is good and there is a bubble around the corner and this is about to burst.

From this stimulating post on WSJ Blog, I got this speech from Ben which he gave in 2002. In this he talks about the bubbles in asset markets and whether monetary policy should be used to prick the bubbles? Read Stephen Ceccheti’s superb views as well on this subject; I do cover it in the end as well.

To cut the story short, Ben’s answer is Mon Pol should only be used to monitor inflation, nothing more nothing less. Instead of Mon Pol use 

…..micro-level policies including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed.

Why shouldn’t we use Mon Pol for the same?

1. Identifying a bubble: Calculating fundamental values of assets is difficult. To say it is a bubble, Fed needs a better pricing model than that adopted by finance professionals whose collective information is reflected in asset-market prices.

Ben believes prices are better determined in the financial markets and any belief that Fed has a better model would lead to analysts focusing more on rumours’ and Fed talk than economics.

He also says various indicators available to find stock prices are not perfect hence one cannot say whether there is a bubble at all he cites an example by saying that Shiller and Campbell had made a presentation to Fed Board using dividend-price ratios saying that markets were overvalued (precisely 3 times the fundamental value). But the desired correction did not happen.

Then he cites a study by Borio and Lowe where they use bank credit as a measure of bubble. Ben superbly points out that what is needed is regulatory supervision that ensures financial institutions are lending prudentially (KYC norms are followed etc). With deposit insurance present financial institutions (mainly banks) may not look at KYC and lend leading to crisis later. He adds:

When this moral hazard is present, credit flows rapidly into inelastically supplied assets, such as real estate. Rapid appreciation is the result, until the inevitable albeit belated regulatory crackdown stops the flow of credit and leads to an asset-price crash. Bubbles of this type may be identifiable to some extent after they have begun, but the right policy is to do the financial deregulation correctly–that is, in a way that does not allow speculative misuse of the safety net–in the first place. Or failing that, to intervene and fix the problem when it is recognized

2. Mon Pol is not the right tool: BB says:

If a bubble–a speculative mania, in the more colorful language of the past–is actually in progress, then investors are presumably expecting outsized returns: 10, 15, 20 percent or more annually. Is it plausible that an increase of ½ percentage point in short-term interest rates, unaccompanied by any significant slowdown in the broader economy, will induce speculators to think twice about their equity investments? All we can conclude with much confidence is that the rate hike will tend to weaken the macroeconomic fundamentals through the usual channels, while the asset bubble, if there is one, may well proceed unchecked.

So, if a Central Bank does raise interest rates to check bubbles at best it would lead to slowdown in economy and he gives a very good example of this via the Great Depression in 1929.…..

The correct interpretation of the 1920s, then, is not the popular one–that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy, as Benjamin Strong had predicted, was to slow the economy–both domestically and, through the workings of the gold standard, abroad. The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash. 

Wow! Reading Bernanke really helps. How do you explain so many things in so few pages?Bernanke however does not include the kinds of asset bubbles one needs to look at.

Primarily there are two assets, which pose trouble, equity and real estate. (Commodities would be included in research now) And there is a difference as Ceccheti points out:

In thinking about the impact of bubbles, it is important to distinguish equity from property prices. While they affect the economy through similar channels, the magnitudes tend to be different. Booms and busts in equity prices are much less damaging to an economy than soaring property prices. There are two reasons for this. First, individual consumption decisions are much more sensitive to changes in housing prices than to fluctuations in equity prices. Second, in countries where housing purchases are financed by borrowing (as in the US, the UK, and a number of other countries), bank balance sheets are exposed to the impact of the crash.

How much more damage by real estate? Again from Ceccheti,

… the April 2003 World Economic Outlook, the IMF reported that the average equity price bust lasts for 2½ years and is associated with a 4% GDP loss that affects both consumption and investment. While less frequent, housing price busts last nearly twice as long and have been associated with output losses that are twice as large because of what happens to banks.

Well why do bubbles actually happen? Well the root cause is leverage as people borrow against an asset (which they expect to rise in future). So you need to tone down the leverage via policies.

With equities some correction still happens as short-selling mechanism is possible but with that options not easily doable with houses the prices would continue to rise. Well this is tremendous insight.

Ceccheti also says Mon Pol may not be the right tool to take care of bubbles, and does suggest measures like higher margins for checking equity bubbles and increasing net worth margins for the borrower etc for correcting housing bubbles. But says there efficacy has to be evaluated and till then Mon Pol remains the only tool.

As both the article and speech were written some years back what do we see now? In India, RBI keeps a tab on housing prices not via interest rates but through other policies. It looks at how much of the loans go towards housing, tinkers with the risk weightage associated with housing loans etc.

So a consensus is building on alternative measures for checking asset prices.

Before I close, the idea that Mon Pol should be used for asset prices is gaining ground. This recent article by Leijonhufvud and latest BIS annual report all talk about accommodative monetary policies being responsible for the recent asset price rise.

Assorted Links

June 29, 2007

1. As was expected, Fed leaves rates unchanged at 5.25%. In yet another excellent pointer from WSJ Blog, see how the FOMC statement has changed from the previous ones. This is super stuff.

2. Wall Street vs Silicon Valley. Google rules on US campuses. Thanks to WSJ Blog once again. Another pointer is the article by Hal Varian on how ipods are made…It is a global ipod with components coming from all over the world.

3. Montek Singh Ahluwalia’s interview in BS is a nice read.  He says inclusiveness is not just about poverty reduction. Unlike most (including me) he says reforms haven’t slowed down.

We have restructured policies to induct public-private partnership (PPP) into infrastructure, to re-energise agriculture and also to improve health and education. Tax reform has continued and yielded excellent results. The near universal adoption of VAT by states and the spread of the service tax net are particularly important.

I recognise that the financial press often complains that reforms have slowed down. I think this it is partly because they focus on one or two areas like labour reforms, where we have not made progress, because we simply do not have the political consensus to move forward.

%d bloggers like this: