At the Kansas City Federal Reserve’s annual economic symposium at Jackson Hole, Wyoming, Federal Reserve Chairman Ben Bernanke provided a sketch of last year’s financial panic, laid out an account on how the contagion rippled through the financial system, discussed the importance of good liquidity management for the financial sector, and reaffirmed the central bank’s role as a lender of last resort. Noteworthy as that address was, the paper he and Mark Gertler presented at the 1999 symposium remains relevant for some of the lessons it provides.
Some highlights follow:
• Two possible sources of “non-fundamental” fluctuations in asset prices involve “poor regulatory practice” and “imperfect rationality on the part of investors.” There is evidence that financial liberalization that led to poor regulatory practices led to asset price booms in Japan in the 1980s, Scandinavia in the 1990s, among other places. Often financial liberalization led to large capital inflows. Research by Charles Kindleberger revealed that a large proportion of such inflows was allocated to financial investments, touching off a rapid rise in asset prices.
• Problems arise when financial liberalization is not coordinated with the regulatory safety net. Examples of the regulatory safety net include bank deposit insurance and a central bank’s lender-of-last-resort commitments. In such cases, excessive risk-taking can unfold. Bernanke and Gertler explained, “If liberalization gives additional power to private lenders and borrowers while retaining government guarantees of liabilities, excessive risk-taking and speculation will follow, leading, in many cases, to asset-price booms.” Bernanke and Gertler added that this development characterized “reasonably” the S&L crisis in the U.S., the financial crisis in Japan following the collapse of its real estate and stock market bubbles, and the Asian financial crisis, among others.
• Asset prices have an impact on the real economy. The most important connection between asset prices and the real economy is through the balance sheet channel. Cash flows and balance sheet strength are important determinants of agents’ lending and borrowing capacity. The balance sheet channel helps explain the “financial accelerator” effect under which macroeconomic activity strengthens during a rapid rise in asset prices. It also helps explain the slowdown, and sometimes, debt-deflation mechanism, that develops following a sharp contraction in asset prices.
As a caveat, it should be noted that there is significant disagreement on the issue of whether monetary policy should respond aggressively to potential asset bubbles, particularly real estate bubbles that involve large amounts of leverage. The Bernanke-Gertler paper argued against intervention when it came to stock market bubbles. It did not address real estate bubbles. The paper asserted that when monetary policy aggressively targets consumer and producer inflation, “whether policy also responds independently to stock prices is not of great consequence.” In contrast, in recent years, the International Monetary Fund has increasingly called for greater consideration of asset prices in the rubric of inflation measurements.
Nevertheless, in the end, the Bernanke-Gertler paper offers policy makers some important guidance in developing a post-financial crisis regulatory framework. Most importantly, policy makers will need to ensure that the regulatory regime is compatible with the regulatory safety net. As a corollary, policy makers will need to take steps to ensure that the extraordinary intervention during the financial crisis will not breed the kind of moral hazard that could fuel a fresh wave of excessive risk-taking in the near- or medium-term. One key to such an approach would entail addressing the “too big to fail” issue. If that issue is resolved, then the extraordinary intervention would be perceived as a rare exception, not the norm of what could be expected should a future crisis erupt.
For now, even as prospective regulatory reforms have been introduced, the overall process is still in its early stages. For that reason, the 1999 Bernanke-Gertler paper can offer policy makers some valuable guidance as they pursue regulatory reform.
&&
Showing posts with label asset bubbles. Show all posts
Showing posts with label asset bubbles. Show all posts
Monday, August 24, 2009
Tuesday, July 21, 2009
Policy Makers Need to Keep in Mind the Law of Unintended Consequences
The law of unintended consequences dictates that the deliberate decisions, choices, or actions of people, business, or government can lead to unanticipated or unintended consequences. In other words, although the purpose of a decision, choice, or action might be beneficial, that decision, choice, or action could have unanticipated effects—benign or adverse—that have little to do with the original intent behind that decision, choice, or action.
Such outcomes are possible because people lack prescience. No person, institution, or technology offers a crystal clear window to the future. Aside from natural phenomena, human behavior and interactions are so complex that the possible range of future effects of a given decision, choice, or action are all but infinite. As a result, a range of future effects is both unknown and unknowable.
Recent examples abound.
On March 30, 2009, The New York Times reported:
Amid the shaky economy of the last couple of years, housing has emerged as the central pillar of support. The market for housing has become less volatile and less prone to oversupply than before; it has also become the Federal Reserve's main lever for reviving the economy…
Housing prices have been increasing faster than general inflation for several years, and they have accelerated in recent months to their fastest real rate of gain in decades.
All this has bolstered consumer spending and helped salve the wounds that the falling stock market inflicted on households.
On July 20, 2009, The Washington Post reported:
The chemicals, called hydrofluorocarbons (HFCs), were introduced widely in the 1990s to replace ozone-depleting gases used in air conditioners, refrigerators and insulating foam.
They worked: The earth's protective shield seems to be recovering.
But researchers say what's good for ozone is bad for climate change. In the atmosphere, these replacement chemicals act like "super" greenhouse gases, with a heat-trapping power that can be 4,470 times that of carbon dioxide.
In both examples, the benefits seemed clear. The downside risks appeared to be limited, if they existed at all. Yet, housing proved to be no “Rock of Gibraltar” in the medium-term, as a giant bubble developed and burst, creating severe global synchronized recessions. In the latter case, addressing one environmental problem created a potential hazard for addressing another.
The law of unintended consequences is particularly relevant today. In the wake of unprecedented monetary and fiscal policy stimulus, policy makers need to be looking ahead to the future and developing scenarios for at least some of the possible unintended consequences that might arise. Given the enormous scope of policy decisions, the exercise needs to be particularly robust.
Possible unintended consequences include, but are not limited to:
• A return of reckless decision making on account of moral hazard resulting from bailouts and other extraordinary government assistance.
• The impact of increased market concentration that results from the failure of small financial services firms at a time when the federal government has acted as a guarantor for those that were deemed “too big to fail.” Amplification of such a risk should the federal government fail to develop an adequate regulatory response to the “too big to fail” issue.
• Political goals crowding out business objectives for firms that had received massive federal aid.
• A shift in investor sentiments concerning U.S. Government debt on account of a combination of increased debt from the fiscal stimulus and possible health care reform legislation should that legislation lack budget neutrality and fail to address the persistent growth of health expenditures in excess of nominal GDP, which amounts to a long-term expenditures bubble so to speak.
• A reappearance of excessive inflation from a delayed scaling back of the fiscal and monetary policy stimulus or the onset of a second recession from the premature or overly aggressive scaling back of the stimulus.
• A fundamental shift in risk perceptions that could lead to the emergence of a future housing bubble should the federal government make mortgage payments for unemployed homeowners.
• A slowing of the long-term economic growth trajectory should the federal government rely too heavily on tax hikes to fund new programs, finance existing mandatory spending programs without major reforms, or try to reduce its annual budget deficits.
• The impact on public- and private-sector finances and investment should long-term interest rates embark on a secular rise.
• The overall impact on economic growth, market risks, and innovation should the federal government’s post-financial crisis regulatory reforms result in excessive or inadequate regulation.
• A shift in investor sentiments concerning the U.S. dollar resulting from current and expected policy moves, economic outcomes, and a long-term diminishing of the dollar’s role as a world reserve currency.
• The fiscal and monetary policy proves sufficiently successful to bolster public confidence in government’s role of addressing economic crises that a new burst of economic euphoria unfolds.
It will be important that policy makers have a contingency plan for each of these scenarios, among others. In addition, the contingency plans will need to be sufficiently robust to lay out possible consequences of those measures, possible antidotes for those consequences, and contingency measures for those antidotes, as well.
In the post-housing bubble years, the law of unintended consequences is especially relevant given the magnitude of policy measures that have been undertaken and are likely to be pursued in the near-term. Although some risks are unknown or unknowable, it is imperative that policy makers take a rigorous approach toward identifying and addressing major risks in a proactive fashion. Neglect of this essential responsibility could have particularly high costs, especially when long-term economic and geopolitical trends are added to the mix.
&&
Such outcomes are possible because people lack prescience. No person, institution, or technology offers a crystal clear window to the future. Aside from natural phenomena, human behavior and interactions are so complex that the possible range of future effects of a given decision, choice, or action are all but infinite. As a result, a range of future effects is both unknown and unknowable.
Recent examples abound.
On March 30, 2009, The New York Times reported:
Amid the shaky economy of the last couple of years, housing has emerged as the central pillar of support. The market for housing has become less volatile and less prone to oversupply than before; it has also become the Federal Reserve's main lever for reviving the economy…
Housing prices have been increasing faster than general inflation for several years, and they have accelerated in recent months to their fastest real rate of gain in decades.
All this has bolstered consumer spending and helped salve the wounds that the falling stock market inflicted on households.
On July 20, 2009, The Washington Post reported:
The chemicals, called hydrofluorocarbons (HFCs), were introduced widely in the 1990s to replace ozone-depleting gases used in air conditioners, refrigerators and insulating foam.
They worked: The earth's protective shield seems to be recovering.
But researchers say what's good for ozone is bad for climate change. In the atmosphere, these replacement chemicals act like "super" greenhouse gases, with a heat-trapping power that can be 4,470 times that of carbon dioxide.
In both examples, the benefits seemed clear. The downside risks appeared to be limited, if they existed at all. Yet, housing proved to be no “Rock of Gibraltar” in the medium-term, as a giant bubble developed and burst, creating severe global synchronized recessions. In the latter case, addressing one environmental problem created a potential hazard for addressing another.
The law of unintended consequences is particularly relevant today. In the wake of unprecedented monetary and fiscal policy stimulus, policy makers need to be looking ahead to the future and developing scenarios for at least some of the possible unintended consequences that might arise. Given the enormous scope of policy decisions, the exercise needs to be particularly robust.
Possible unintended consequences include, but are not limited to:
• A return of reckless decision making on account of moral hazard resulting from bailouts and other extraordinary government assistance.
• The impact of increased market concentration that results from the failure of small financial services firms at a time when the federal government has acted as a guarantor for those that were deemed “too big to fail.” Amplification of such a risk should the federal government fail to develop an adequate regulatory response to the “too big to fail” issue.
• Political goals crowding out business objectives for firms that had received massive federal aid.
• A shift in investor sentiments concerning U.S. Government debt on account of a combination of increased debt from the fiscal stimulus and possible health care reform legislation should that legislation lack budget neutrality and fail to address the persistent growth of health expenditures in excess of nominal GDP, which amounts to a long-term expenditures bubble so to speak.
• A reappearance of excessive inflation from a delayed scaling back of the fiscal and monetary policy stimulus or the onset of a second recession from the premature or overly aggressive scaling back of the stimulus.
• A fundamental shift in risk perceptions that could lead to the emergence of a future housing bubble should the federal government make mortgage payments for unemployed homeowners.
• A slowing of the long-term economic growth trajectory should the federal government rely too heavily on tax hikes to fund new programs, finance existing mandatory spending programs without major reforms, or try to reduce its annual budget deficits.
• The impact on public- and private-sector finances and investment should long-term interest rates embark on a secular rise.
• The overall impact on economic growth, market risks, and innovation should the federal government’s post-financial crisis regulatory reforms result in excessive or inadequate regulation.
• A shift in investor sentiments concerning the U.S. dollar resulting from current and expected policy moves, economic outcomes, and a long-term diminishing of the dollar’s role as a world reserve currency.
• The fiscal and monetary policy proves sufficiently successful to bolster public confidence in government’s role of addressing economic crises that a new burst of economic euphoria unfolds.
It will be important that policy makers have a contingency plan for each of these scenarios, among others. In addition, the contingency plans will need to be sufficiently robust to lay out possible consequences of those measures, possible antidotes for those consequences, and contingency measures for those antidotes, as well.
In the post-housing bubble years, the law of unintended consequences is especially relevant given the magnitude of policy measures that have been undertaken and are likely to be pursued in the near-term. Although some risks are unknown or unknowable, it is imperative that policy makers take a rigorous approach toward identifying and addressing major risks in a proactive fashion. Neglect of this essential responsibility could have particularly high costs, especially when long-term economic and geopolitical trends are added to the mix.
&&
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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