Tomorrow, the opening of the P5+1 (Permanent Members of the Security Council + Germany)-Iran talks is likely to produce few significant changes. Instead, the P5+1 will likely seek assurances that Iran’s nuclear program is intended for peaceful purposes, Iran works with the International Atomic Energy Agency (IAEA) to resolve outstanding issues, and Iran takes a much more transparent approach with its nuclear program. Iran, on the other hand, is likely to try to shift the emphasis to broader issues outside the scope of its nuclear program.
In part, Iran’s incentive to remain intransigent is the result of its calculation that no severe sanctions are likely. Instead, because Iran’s economy is not highly integrated with the world’s major economies, sanctions concerning oil industry parts or financial flows are likely to have only a limited adverse impact. With Iran recently entering into an agreement to purchase refined petroleum products from Venezuela, a sanctions regime that deprives Iran of such products is also unlikely to be very effective. The single sanction that could break Iran, namely its ability to sell oil on the world market, is highly unlikely.
Briefly, it is that sanction that would hold the best promise of breaking Iranian rigidity for several reasons:
• Petroleum accounts for 80% of Iran’s exports. Oil revenue amounts to 113% of Iran’s imports. Without oil revenue, Iran’s current account deficit would explode.
• Just five countries account for nearly 72% of Iran’s oil exports: Japan, China, India, South Korea, and Italy.
• Venezuela, with which Iran has been steadily deepening relations, is an oil exporter and would be unlikely to purchase crude oil from Iran.
• A shutdown of Iran’s oil sector would exacerbate that country’s 12.5% unemployment rate.
However, to bring the small number of countries, including China, into alignment on a severe sanctions regime that targets Iran’s oil industry would likely require the United States taking measures to assure their access to oil at a reasonable price. One mechanism that could be explored would entail the U.S. committing to sell oil from its strategic petroleum reserve at a discount from world prices to buffer the impact of the loss of Iranian oil on those countries. Although such an approach is not assured to produce the commitment to such a sanctions regime, should it become necessary, it could constitute a step in that direction.
Beyond diplomacy, the policy options involved become much less pleasant. One such option would constitute the construction of a credible deterrent e.g., in the form of a U.S. commitment that would translate into Iran’s destruction were Iran to launch or attempt a nuclear strike and/or proliferate nuclear weapons. Even then, the Middle East’s balance of power would be dramatically altered on dimensions concerning state power, the capabilities of non-state actors, and in terms of the Sunni-Shia rivalry. Another option would entail military strikes. Such strikes would likely be costly considering the need for some ground component to destroy buried nuclear facilities and risk of retaliation by Iran and its proxies (Hamas and Hezbollah). Such strikes might only briefly delay Iran’s attaining a nuclear weapons capacity, especially if Iran has additional hidden facilities.
Therefore, given tradeoffs involved were diplomacy to fail, it makes sense to put the pieces in place to maximize the prospects of diplomatic success keeping in mind that a diplomatic breakthrough would need to accommodate the core needs of all parties. In principle, a diplomatic breakthrough would probably allow Iran an ability to maintain a civil nuclear energy industry (Iran’s core need) subject to an intrusive verification regime (the international community’s core need in minimizing the risk of nuclear proliferation). A truly rigorous sanctions regime that targets Iran’s oil industry would probably be key to facilitating the negotiating process should Iran take an implacable stand. An oil-sharing agreement to shield leading importers of Iranian oil from the impact of such a sanctions regime would probably strengthen prospects of building such a sanctions regime.
&&
Showing posts with label China. Show all posts
Showing posts with label China. Show all posts
Wednesday, September 30, 2009
Friday, July 24, 2009
IMF Concludes Its Consultation with China
Earlier this week, the International Monetary Fund (IMF) announced that its Executive Board had completed its consultations with China. The IMF released a summary of the consultation. Key findings included:
• China’s robust fiscal and monetary policy stimuli facilitated an economic recovery. China’s policies have contributed to regional and global economic stability.
• Global economic challenges may make it difficult for the world’s economies to absorb China’s increased production capacity. As a result, the IMF expressed support for China’s measures aimed at boosting domestic consumption spending and reducing China’s reliance on exports.
• China’s low level of public debt should afford the country flexibility in pursuing additional targeted fiscal stimulus measures.
• The IMF called for China to closely monitor its financial system for indications of a decline in credit quality.
• The IMF welcomed China’s intent to participate in its Financial Sector Assessment Program to identify possible areas for financial system reform.
To date, the ongoing discussions in academic and regulatory circles in China concerning the possible deployment of monetary policy to mitigate the risk of an emergent real estate bubble should provide some degree of comfort when it comes to avoiding a serious deterioration in credit quality. Possible monetary tightening would tend to squeeze out marginal borrowers.
Nonetheless, given the limits of monetary policy, regulators will need to carefully watch bank lending for signs that loans are being concentrated disproportionately in any single economic sector such as real estate, down payments are being reduced significantly, or up-front inducements to encourage borrowing are being offered. Should capital inflows pick up dramatically in coming quarters, that situation would also warrant close monitoring, as such inflows could fuel a credit boom that provides access even to marginal borrowers. Those were some of the symptoms of the decay that took place in lending standards during the run-up of the recent U.S. housing bubble.
So far, China’s policy makers appear to have taken to heart a possible role for monetary policy in mitigating the rise of asset bubbles. It remains to be seen how China’s regulators will respond in seeking to preclude any material decline in credit quality, particularly as China’s economy experiences a return of robust growth.
&&
• China’s robust fiscal and monetary policy stimuli facilitated an economic recovery. China’s policies have contributed to regional and global economic stability.
• Global economic challenges may make it difficult for the world’s economies to absorb China’s increased production capacity. As a result, the IMF expressed support for China’s measures aimed at boosting domestic consumption spending and reducing China’s reliance on exports.
• China’s low level of public debt should afford the country flexibility in pursuing additional targeted fiscal stimulus measures.
• The IMF called for China to closely monitor its financial system for indications of a decline in credit quality.
• The IMF welcomed China’s intent to participate in its Financial Sector Assessment Program to identify possible areas for financial system reform.
To date, the ongoing discussions in academic and regulatory circles in China concerning the possible deployment of monetary policy to mitigate the risk of an emergent real estate bubble should provide some degree of comfort when it comes to avoiding a serious deterioration in credit quality. Possible monetary tightening would tend to squeeze out marginal borrowers.
Nonetheless, given the limits of monetary policy, regulators will need to carefully watch bank lending for signs that loans are being concentrated disproportionately in any single economic sector such as real estate, down payments are being reduced significantly, or up-front inducements to encourage borrowing are being offered. Should capital inflows pick up dramatically in coming quarters, that situation would also warrant close monitoring, as such inflows could fuel a credit boom that provides access even to marginal borrowers. Those were some of the symptoms of the decay that took place in lending standards during the run-up of the recent U.S. housing bubble.
So far, China’s policy makers appear to have taken to heart a possible role for monetary policy in mitigating the rise of asset bubbles. It remains to be seen how China’s regulators will respond in seeking to preclude any material decline in credit quality, particularly as China’s economy experiences a return of robust growth.
&&
Monday, July 20, 2009
China Regulator Sounds Off on Real Estate Lending
Less than two weeks after a leading Chinese academic suggested that China’s central bank should signal its commitment to a stable monetary policy so as to help prevent the development of possible asset bubbles, a Chinese regulator expressed concern about increasing indications of overheated bank lending to the real estate sector.
On Sunday, CNBC reported:
China's top banking regulator on Sunday warned of the risks from surging bank lending, singling out the dangers of unhealthy growth in the property market.
"(We) must control the risk of real estate loans," said Liu Mingkang, the head of the China Banking Regulatory Commission, adding that measures must be taken to better evaluate the creditworthiness of borrowers.
The growing concern in China about the potential risk of a possible real estate bubble, probably one or more regional bubbles, is well-founded.
• Banking crises have often been preceded by credit booms. An IMF Working Paper written by Luc Laeven ad Fabian Valencia found that credit booms preceded about 30% of banking crises.
• Real estate busts in which the prices of homes, farms, and/or commercial property fell have often led to waves of bank failures.
• Research has shown that shifts in capital flows from earlier asset bubbles can contribute to the rise of asset bubbles elsewhere. Hence, with the U.S. housing bubble having burst in recent years, some capital in search of appreciation could flow to a growing economy and rapidly rising asset markets in China.
• According to research by the International Monetary Fund, housing busts typically lead to recessions that are twice as deep and twice as long as those associated with equities busts.
• Considering the still fragile shape of economies in parts of Asia, Europe, and the Americas, including financial system fragility in some of those locations, the rise and fall of a real estate bubble in China could send the kind of fresh shock rippling through the global financial system that could suffocate any economic recovery that might be underway in various Asian, European, and North and South American economies at that time. During the Great Depression, a relentless wave of economic shocks rolled across the European and American economies inhibiting any early recovery.
• Should an asset bubble burst in China, its fallout could sufficiently damage already-weak financial institutions in numerous major money centers so as to lead to a prolonged impairment of the credit creation process. Such a development would have the potential to lead to a prolonged period of regional or global economic stagnation.
• In China, a significant real estate bubble could undermine domestic economic growth and job creation. Those developments could lead to a further intensification of forces contributing to recent ethnic strife in parts of China.
All said, China has ample reason to be concerned about the possible rise of a major regional housing bubble or bubbles. Given the stakes involved, China might well choose to break new monetary policy ground in attempting to deploy monetary policy toward reducing the risk of the emergence of a real estate bubble.
&&
On Sunday, CNBC reported:
China's top banking regulator on Sunday warned of the risks from surging bank lending, singling out the dangers of unhealthy growth in the property market.
"(We) must control the risk of real estate loans," said Liu Mingkang, the head of the China Banking Regulatory Commission, adding that measures must be taken to better evaluate the creditworthiness of borrowers.
The growing concern in China about the potential risk of a possible real estate bubble, probably one or more regional bubbles, is well-founded.
• Banking crises have often been preceded by credit booms. An IMF Working Paper written by Luc Laeven ad Fabian Valencia found that credit booms preceded about 30% of banking crises.
• Real estate busts in which the prices of homes, farms, and/or commercial property fell have often led to waves of bank failures.
• Research has shown that shifts in capital flows from earlier asset bubbles can contribute to the rise of asset bubbles elsewhere. Hence, with the U.S. housing bubble having burst in recent years, some capital in search of appreciation could flow to a growing economy and rapidly rising asset markets in China.
• According to research by the International Monetary Fund, housing busts typically lead to recessions that are twice as deep and twice as long as those associated with equities busts.
• Considering the still fragile shape of economies in parts of Asia, Europe, and the Americas, including financial system fragility in some of those locations, the rise and fall of a real estate bubble in China could send the kind of fresh shock rippling through the global financial system that could suffocate any economic recovery that might be underway in various Asian, European, and North and South American economies at that time. During the Great Depression, a relentless wave of economic shocks rolled across the European and American economies inhibiting any early recovery.
• Should an asset bubble burst in China, its fallout could sufficiently damage already-weak financial institutions in numerous major money centers so as to lead to a prolonged impairment of the credit creation process. Such a development would have the potential to lead to a prolonged period of regional or global economic stagnation.
• In China, a significant real estate bubble could undermine domestic economic growth and job creation. Those developments could lead to a further intensification of forces contributing to recent ethnic strife in parts of China.
All said, China has ample reason to be concerned about the possible rise of a major regional housing bubble or bubbles. Given the stakes involved, China might well choose to break new monetary policy ground in attempting to deploy monetary policy toward reducing the risk of the emergence of a real estate bubble.
&&
Friday, July 17, 2009
Verleger Prediction of $20 Oil Later This Year Is Highly Unlikely To Verify
On Thursday, Bloomberg.com reported that oil market analyst Philip Verleger predicted that the price of crude oil would fall to $20 per barrel later this year. If the price of crude oil were to drop that low, it would mark the lowest price since February 7, 2002 when crude oil ended trading at $19.64 per barrel.
A closer examination of historic data and underlying fundamentals suggests that a scenario of $20 per barrel oil later this year has little chance at verifying. Although the price of crude oil reached $72.68 per barrel on June 11 before falling just over 18% to $59.52 per barrel on July 14, that recent sharp decline does not presage an imminent crash in oil prices.
• Over the past quarter-century, once the price of crude oil had risen 15% or more above the price at which it had first fallen 40% or more on a year-to-year basis, that outcome was a strong signal that the market bottom had already been reached. Since 1983, there were four occasions on which the market provided such a signal. Over the following 8 months from the date at which the price of crude oil met that recovery threshold, the price of oil remained 40% or more above the bottom that had previously been reached.
During the four previous signals, the price of crude oil ranged from as low as 132.7% of the bottom price to as high as 232.00% of the bottom price during the 8 months following the signal. The low price achieved following the signal had less fluctuation than the overall range, varying from 132.2% to 145.5% of the bottom price.
Assuming that the $33.87 per barrel price that was reached on December 19, 2008 winds up being the bottom—as is strongly suggested by the quarter-century historical experience—and the earlier historic data is representative, that would imply that the price of crude oil would range from as low as $44.93 per barrel to as high $78.58 per barrel in the May 28, 2009-January 28, 2010 timeframe. To date, the price of crude oil has closed as low as $59.52 per barrel (July 14) and as high as $72.68 per barrel (June 11) during the opening part of that period.
• Global crude oil stocks had been rising but could avert dangerous levels. Global stocks had risen 10.4 million barrels in April to levels that were 7.5% above the comparable 2008 figure. However, according to data from the U.S. Energy Information Administration’s Weekly Petroleum Status Report, U.S. crude oil stocks had increased by almost 16 million barrels during that timeframe. In other words, U.S. stocks had played a disproportionate role in leading global stocks higher. Since then, U.S. oil inventories have peaked and begun to fall. As of the four-week period ending July 10, 2009, U.S. crude oil stocks had fallen nearly 30 million barrels from their peak during the same period ended May 1.
That trend could continue until early- to mid-September. Typically, as summer driving season concludes, U.S. inventories begin to increase until heating season sets in during the late-November to early-December period.
During the 2006-2008 timeframe, U.S. oil inventories rose about 1.2 million barrels per week until heating oil season commenced. During the extreme financial market turmoil last autumn, U.S. oil consumption fell sharply and U.S. crude oil stocks rose by about 2.8 million barrels per week. That kind of increase in oil inventories that sent the price of crude oil crashing 76.7% from a high of $145.29 to $33.87 in a matter of months is not likely, as the latest macroeconomic data suggests that a number of major economies are stabilizing. A few, including China, have begun to experience more robust growth, with the Chinese economy expanding 7.9% on a year-to-year basis from a large fiscal stimulus and an extraordinary monetary policy stimulus. That latter stimulus, if it is reeled in, could touch off the development of asset bubbles. Already, the Shanghai Composite has risen 75% this year. But that development is not likely to impact China’s growth very near-term.
Stabilization of the U.S. economy and a return of growth for the U.S. economy and some major international economies over the coming months should begin to pare product inventories (gasoline, distillate fuel, etc.), as well as lead to a gradual increase in global crude oil demand. In its July 2009 report, OPEC estimates that global crude oil demand will rise from 82.80 million barrels per day in the Second Quarter to 84.84 million barrels per day in the Fourth Quarter. If that scenario begins to play out, an abnormally sharp rebound in U.S. crude oil stocks and a rise of global inventories to dangerous levels will become less likely. In other words, the kind of crippling oil glut that could cause a crash in oil prices would become unlikely.
On the supply-side, OPEC is likely to remain risk-averse through much or all of the remainder of this year. So long as U.S. consumption, which has recently flat-lined in the 18.0 million to 18.5 million barrels per day range since mid-spring, down 8%-12% from 2007- and 2008-level consumption, OPEC is likely to remain cautious about increasing production.
Moreover, considering that OPEC continues to monitor global crude oil stocks, and had even used such stocks as a yardstick in setting production quotas in the recent past when oil prices were rocketing toward their July 2007 peak, OPEC is likely to err on the side of caution in restraining its member country production. Its restraint to some recent calls for an increase in oil production after oil prices had doubled from their December 2008 low underscores OPEC’s caution.
As a result, OPEC is not likely to increase its oil production through much or all of the rest of this year, even as demand gradually increases. That production posture should help mitigate the risk of the kind of enormous oil glut necessary to bring about a fresh collapse in the price of crude oil.
In the end, if the Verleger scenario is to pan out, the world would need to witness a significant new regional or global shock that would erase the recent trend toward economic stabilization and set off another dramatic economic contraction on a global basis. While scenarios such as a collapse of Eastern Europe’s banking system could trigger such an outcome, such scenarios are not assured.
Conclusion:
Historical experience, underlying macroeconomic dynamics, and OPEC’s restraint indicate that the price of crude oil is unlikely to collapse to $20 per barrel later this year. Instead, a possible mini-bottom in the $40 per barrel to $50 per barrel range during price fluctuations is far more plausible through the remainder of this year.
&&
A closer examination of historic data and underlying fundamentals suggests that a scenario of $20 per barrel oil later this year has little chance at verifying. Although the price of crude oil reached $72.68 per barrel on June 11 before falling just over 18% to $59.52 per barrel on July 14, that recent sharp decline does not presage an imminent crash in oil prices.
• Over the past quarter-century, once the price of crude oil had risen 15% or more above the price at which it had first fallen 40% or more on a year-to-year basis, that outcome was a strong signal that the market bottom had already been reached. Since 1983, there were four occasions on which the market provided such a signal. Over the following 8 months from the date at which the price of crude oil met that recovery threshold, the price of oil remained 40% or more above the bottom that had previously been reached.
During the four previous signals, the price of crude oil ranged from as low as 132.7% of the bottom price to as high as 232.00% of the bottom price during the 8 months following the signal. The low price achieved following the signal had less fluctuation than the overall range, varying from 132.2% to 145.5% of the bottom price.
Assuming that the $33.87 per barrel price that was reached on December 19, 2008 winds up being the bottom—as is strongly suggested by the quarter-century historical experience—and the earlier historic data is representative, that would imply that the price of crude oil would range from as low as $44.93 per barrel to as high $78.58 per barrel in the May 28, 2009-January 28, 2010 timeframe. To date, the price of crude oil has closed as low as $59.52 per barrel (July 14) and as high as $72.68 per barrel (June 11) during the opening part of that period.
• Global crude oil stocks had been rising but could avert dangerous levels. Global stocks had risen 10.4 million barrels in April to levels that were 7.5% above the comparable 2008 figure. However, according to data from the U.S. Energy Information Administration’s Weekly Petroleum Status Report, U.S. crude oil stocks had increased by almost 16 million barrels during that timeframe. In other words, U.S. stocks had played a disproportionate role in leading global stocks higher. Since then, U.S. oil inventories have peaked and begun to fall. As of the four-week period ending July 10, 2009, U.S. crude oil stocks had fallen nearly 30 million barrels from their peak during the same period ended May 1.
That trend could continue until early- to mid-September. Typically, as summer driving season concludes, U.S. inventories begin to increase until heating season sets in during the late-November to early-December period.
During the 2006-2008 timeframe, U.S. oil inventories rose about 1.2 million barrels per week until heating oil season commenced. During the extreme financial market turmoil last autumn, U.S. oil consumption fell sharply and U.S. crude oil stocks rose by about 2.8 million barrels per week. That kind of increase in oil inventories that sent the price of crude oil crashing 76.7% from a high of $145.29 to $33.87 in a matter of months is not likely, as the latest macroeconomic data suggests that a number of major economies are stabilizing. A few, including China, have begun to experience more robust growth, with the Chinese economy expanding 7.9% on a year-to-year basis from a large fiscal stimulus and an extraordinary monetary policy stimulus. That latter stimulus, if it is reeled in, could touch off the development of asset bubbles. Already, the Shanghai Composite has risen 75% this year. But that development is not likely to impact China’s growth very near-term.
Stabilization of the U.S. economy and a return of growth for the U.S. economy and some major international economies over the coming months should begin to pare product inventories (gasoline, distillate fuel, etc.), as well as lead to a gradual increase in global crude oil demand. In its July 2009 report, OPEC estimates that global crude oil demand will rise from 82.80 million barrels per day in the Second Quarter to 84.84 million barrels per day in the Fourth Quarter. If that scenario begins to play out, an abnormally sharp rebound in U.S. crude oil stocks and a rise of global inventories to dangerous levels will become less likely. In other words, the kind of crippling oil glut that could cause a crash in oil prices would become unlikely.
On the supply-side, OPEC is likely to remain risk-averse through much or all of the remainder of this year. So long as U.S. consumption, which has recently flat-lined in the 18.0 million to 18.5 million barrels per day range since mid-spring, down 8%-12% from 2007- and 2008-level consumption, OPEC is likely to remain cautious about increasing production.
Moreover, considering that OPEC continues to monitor global crude oil stocks, and had even used such stocks as a yardstick in setting production quotas in the recent past when oil prices were rocketing toward their July 2007 peak, OPEC is likely to err on the side of caution in restraining its member country production. Its restraint to some recent calls for an increase in oil production after oil prices had doubled from their December 2008 low underscores OPEC’s caution.
As a result, OPEC is not likely to increase its oil production through much or all of the rest of this year, even as demand gradually increases. That production posture should help mitigate the risk of the kind of enormous oil glut necessary to bring about a fresh collapse in the price of crude oil.
In the end, if the Verleger scenario is to pan out, the world would need to witness a significant new regional or global shock that would erase the recent trend toward economic stabilization and set off another dramatic economic contraction on a global basis. While scenarios such as a collapse of Eastern Europe’s banking system could trigger such an outcome, such scenarios are not assured.
Conclusion:
Historical experience, underlying macroeconomic dynamics, and OPEC’s restraint indicate that the price of crude oil is unlikely to collapse to $20 per barrel later this year. Instead, a possible mini-bottom in the $40 per barrel to $50 per barrel range during price fluctuations is far more plausible through the remainder of this year.
&&
Monday, July 6, 2009
Will China's Central Bank Deploy Monetary Policy Against Asset Price Inflation?
On Saturday, Xia Bin, who heads the financial institute at the State Council Development and Research Center suggested that China’s central bank signal its commitment to a stable money supply in order to prevent an outbreak of asset price inflation. Xia’s call for a broader definition of the objectives of monetary policy is not new.
Since at least 1993, the International Monetary Fund (IMF) has argued that central banks should apply a broader definition to prices than the current consumption and production-based measures they currently employ. In 2000, Henry Kaufman, one of the United States’ leading private economists, wrote, “There is no mandate at the present time for any central bank to take into consideration financial asset prices explicitly in the formation of monetary policy. Nevertheless, the bubbling in the American financial market is an untenable situation.”
Arguments in favor of a broader set of price measures include:
• Capital flows that rush into assets are not picked up by conventional measures of inflation. In the past, sudden and signficant capital inflows have had a destabilizing macroeconomic impact and have precipitated a number of financial crises.
• Excessive asset price inflation can touch off a self-reinforcing situation in which an asset bubble develops.
• Asset bubble growth can crowd out saving. With asset prices rising rapidly, the “wealth effect,” can create disincentives for saving. In fact, that is what happened in the run-up of the recent U.S. housing bubble. Personal saving fell from 5.7% of disposable income in the First Quarter of 1995 to -0.7% of disposable income in the Third Quarter of 2005. Moreover, from the First Quarter of 2005 through the First Quarter of 2008, personal saving averaged just over 0.5% of disposable income.
• Reflecting the decline in personal saving was the onset of a “financial accelerator” effect. During the 1990s, personal consumption accounted for 67.5% of real GDP. During the 2000s, personal consumption had increased to 70.6% of real GDP. Since 2005, personal consumption has averaged 71.2% of real GDP. It was the rise in personal consumption that accounted for much of the growth in real GDP that occurred in the 2000-2007 period. During the 1990s, real GDP expanded an average of 3.1% per year. Non-consumption related items of real GDP rose 2.8% per year. In contrast, during the 2000-2007 timeframe, real GDP grew by 2.5% per year, but the non-consumption items increased by just 1.0% per year.
• All bubbles eventually collapse. When equities, commodities, or real estate bubbles pop, they can result in significant macroeconomic damage.
• Real estate bubbles are particularly hazardous given the amount of debt involved. The collapse of real estate bubbles can create financial system fragility, and frequently a financial sector crisis that can take years to heal. Such a crisis can lead to a severe credit crunch. In turn, the increasing grip of a credit crunch can produce a significant and prolonged recession. The ongoing synchronized global recessions provide an illustration of the dangers of a housing bubble.
The major issue involved in pursuing a broader definition of monetary policy concerns whether central banks can detect formative asset bubbles. In 1999, then Federal Reserve Chairman Alan Greenspan spoke on that issue. He explained that asset bubbles can lead to economic disruptions, but cautioned that they are very difficult to detect and that preempting asset bubbles would require the central bank’s making a judgment that runs counter to the collective decision making of millions of market participants. He stated:
History tells us that sharp abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations…
We can readily describe this process, but to date, economists have been unable to anticipate sharp reversals in confidence… To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors…
Chairman Greenspan’s concerns aside, history has provided a reasonably good guide that could be used as a starting point for determining when asset valuations are rising to levels that are disconnected from economic fundamentals. By indexing asset prices to growth in nominal GDP, a central bank could be alerted for situations where asset prices begin to sharply diverge from economic growth.
That has been the pattern with past asset bubbles. In the years leading to the 1929 stock market crash, stock prices (as measured by the Dow Jones Industrials) suddenly surged wildly higher relative to nominal economic growth.
The same pattern reasserted itself with respect to housing prices (as measured by the seasonally-adjusted Case-Shiller 10-city index, as that index goes back prior to 2000) and mortgage debt (home and multifamily residential mortgages).
In the case of the 1929 stock market crash, during 1927 stock valuations rose to 30% or more above cumulative growth in nominal GDP since 1922. By the end of the year, the Dow Jones Industrials’ increase was almost 60% above the level implied by nominal GDP growth.
With respect to the U.S. housing bubble, as indexed to 1995 valuations, mortgage debt reached that threshold in 2002 and housing prices attained that level a year later. In 2003, mortgage debt had grown more than 40% faster than nominal GDP and in 2004 home prices reached that figure.
What is clear in both cases is that asset valuations were rapidly diverging from economic growth. That is a signature of an “upward panic” or euphoria where market psychology increasingly trumps fundamental factors. In both cases, there was a 1½- to 2½-year window of notice that asset bubble formation was underway.
Perhaps tighter monetary policy might have cut short the expansion of the two asset bubbles. Perhaps the economic fallout in the wake of their premature collapse would have been less than ultimately resulted on account of their having been smaller than when they finally collapsed. That is all speculative.
What will be interesting is to see whether China’s central bank actually steers its monetary policy toward a more comprehensive objective that includes reducing the risk of asset price inflation. Even more important, it will be interesting to see whether that monetary policy approach proves effective in the longer-run.
&&
Since at least 1993, the International Monetary Fund (IMF) has argued that central banks should apply a broader definition to prices than the current consumption and production-based measures they currently employ. In 2000, Henry Kaufman, one of the United States’ leading private economists, wrote, “There is no mandate at the present time for any central bank to take into consideration financial asset prices explicitly in the formation of monetary policy. Nevertheless, the bubbling in the American financial market is an untenable situation.”
Arguments in favor of a broader set of price measures include:
• Capital flows that rush into assets are not picked up by conventional measures of inflation. In the past, sudden and signficant capital inflows have had a destabilizing macroeconomic impact and have precipitated a number of financial crises.
• Excessive asset price inflation can touch off a self-reinforcing situation in which an asset bubble develops.
• Asset bubble growth can crowd out saving. With asset prices rising rapidly, the “wealth effect,” can create disincentives for saving. In fact, that is what happened in the run-up of the recent U.S. housing bubble. Personal saving fell from 5.7% of disposable income in the First Quarter of 1995 to -0.7% of disposable income in the Third Quarter of 2005. Moreover, from the First Quarter of 2005 through the First Quarter of 2008, personal saving averaged just over 0.5% of disposable income.
• Reflecting the decline in personal saving was the onset of a “financial accelerator” effect. During the 1990s, personal consumption accounted for 67.5% of real GDP. During the 2000s, personal consumption had increased to 70.6% of real GDP. Since 2005, personal consumption has averaged 71.2% of real GDP. It was the rise in personal consumption that accounted for much of the growth in real GDP that occurred in the 2000-2007 period. During the 1990s, real GDP expanded an average of 3.1% per year. Non-consumption related items of real GDP rose 2.8% per year. In contrast, during the 2000-2007 timeframe, real GDP grew by 2.5% per year, but the non-consumption items increased by just 1.0% per year.
• All bubbles eventually collapse. When equities, commodities, or real estate bubbles pop, they can result in significant macroeconomic damage.
• Real estate bubbles are particularly hazardous given the amount of debt involved. The collapse of real estate bubbles can create financial system fragility, and frequently a financial sector crisis that can take years to heal. Such a crisis can lead to a severe credit crunch. In turn, the increasing grip of a credit crunch can produce a significant and prolonged recession. The ongoing synchronized global recessions provide an illustration of the dangers of a housing bubble.
The major issue involved in pursuing a broader definition of monetary policy concerns whether central banks can detect formative asset bubbles. In 1999, then Federal Reserve Chairman Alan Greenspan spoke on that issue. He explained that asset bubbles can lead to economic disruptions, but cautioned that they are very difficult to detect and that preempting asset bubbles would require the central bank’s making a judgment that runs counter to the collective decision making of millions of market participants. He stated:
History tells us that sharp abruptly, most often with little advance notice. These reversals can be self-reinforcing processes that can compress sizable adjustments into a very short time period. Panic market reactions are characterized by dramatic shifts in behavior to minimize short-term losses. Claims on far-distant future values are discounted to insignificance. What is so intriguing is that this type of behavior has characterized human interaction with little appreciable difference over the generations…
We can readily describe this process, but to date, economists have been unable to anticipate sharp reversals in confidence… To anticipate a bubble about to burst requires the forecast of a plunge in the prices of assets previously set by the judgments of millions of investors…
Chairman Greenspan’s concerns aside, history has provided a reasonably good guide that could be used as a starting point for determining when asset valuations are rising to levels that are disconnected from economic fundamentals. By indexing asset prices to growth in nominal GDP, a central bank could be alerted for situations where asset prices begin to sharply diverge from economic growth.
That has been the pattern with past asset bubbles. In the years leading to the 1929 stock market crash, stock prices (as measured by the Dow Jones Industrials) suddenly surged wildly higher relative to nominal economic growth.
The same pattern reasserted itself with respect to housing prices (as measured by the seasonally-adjusted Case-Shiller 10-city index, as that index goes back prior to 2000) and mortgage debt (home and multifamily residential mortgages).
In the case of the 1929 stock market crash, during 1927 stock valuations rose to 30% or more above cumulative growth in nominal GDP since 1922. By the end of the year, the Dow Jones Industrials’ increase was almost 60% above the level implied by nominal GDP growth.
With respect to the U.S. housing bubble, as indexed to 1995 valuations, mortgage debt reached that threshold in 2002 and housing prices attained that level a year later. In 2003, mortgage debt had grown more than 40% faster than nominal GDP and in 2004 home prices reached that figure.
What is clear in both cases is that asset valuations were rapidly diverging from economic growth. That is a signature of an “upward panic” or euphoria where market psychology increasingly trumps fundamental factors. In both cases, there was a 1½- to 2½-year window of notice that asset bubble formation was underway.
Perhaps tighter monetary policy might have cut short the expansion of the two asset bubbles. Perhaps the economic fallout in the wake of their premature collapse would have been less than ultimately resulted on account of their having been smaller than when they finally collapsed. That is all speculative.
What will be interesting is to see whether China’s central bank actually steers its monetary policy toward a more comprehensive objective that includes reducing the risk of asset price inflation. Even more important, it will be interesting to see whether that monetary policy approach proves effective in the longer-run.
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