Bubbles: Remember to ask about the mechanism
I see that Bernard Hickey is suggesting we have the RBNZ pop the “housing bubble”. And to do it the Bank should either ignore inflation targeting and hike rates, or do some magic with macroprudential tools!
The ideal RBNZ governor?
Assume a bubble, so lets start with one! I have a list of problems with this type of article even given that 😉 :
- I am nervous about giving non-democratically elected officials too much scope to do “distributional policy”. This is the purpose of fiscal policy, and there is a thin line as soon as we start moving into alternative tools. The Bank recognises this, but the rest of us have to as well! (eg If we are sad about affordability, this is a fiscal policy issue – it has nothing to do with the RBNZ.)
- In terms of financial stability – which is in the Bank’s mandate – they only care about a bubble insofar as it risks bank failure. So the solution is to try to get banks to hold enough capital. Given that, who gives a proverbial about a bubble! If people are willing to overpay in this context, and there are no broad macro ramifications, there is no role for central bank action at all.
- In terms of monetary policy, this matters only if it leads to an excessive increase in demand … in which case they lift rates due to their inflation mandate, there is no need to change anything in that regard.
- And now given you’ve ignored those three points, dear reader, let me throw in something you might not have thought about. How in the name of frik itself do you pop a bubble?
This last point is important, how do you pop a bubble. Lifting interest rates doesn’t usually do it – in fact if it is a “rational bubble” higher interest rates will lead to a larger bubble!
And if it is an “irrational bubble” why the hell will it care about a small shift in interest rates – if people are making magical capital gains, a marginal change in interest rates will be irrelevant to them. Irrational bubbles are likely to be “interest insensitive”. So interest rates miss the point. And if the bubble is driven by “profit hungry leveraged investors” (so incredibly risk loving people), then LVR limits have no impact – as they would never be borrowing off banks in the first place!
We are talking about expectations here, and we are assuming (as we have a bubble that is against the Bank’s forecasts) that the Bank can’t control expectations. Then we are saying “wave a wand and fix it somehow.
All four of these points tell me that having the Reserve Bank “deal with a bubble” is ridiculous. In fact, I find the entire discussion about bubbles so amazingly ad hoc and inconsistent that I cannot believe I haven’t written this post before! What have I been writing for the past six years? (Here is a partial bubble history: I see James wrote this on experiment economics. I talk about Stiglitz and call him orthodox?. I chat about the idea of using the CFR to control inflation – say no, it is more a “structural tool”. I point to Marginal Revolution talking bubbles. Bubbles and transfers from overseas. Complaining new tools aren’t about stopping bubbles. So yea, nothing actually talking about “what a bubble is and how it fits into policy”, opps).
And why aren’t more people making this point apparent. This moves the entire debate to the issue of “are banks stable enough given systemic risk from an asset price realignment” and “is monetary policy appropriate given inflation and the output gap” … which is where everyone involved in policy would actually want it to be right?
It also tells me that political parties saying that will get the RBNZ to do more are really showing two things:
- They don’t want to take any responsibility for actual fiscal policy issues when in government (understandable, who would ever actually want to be in government!)
- They genuinely don’t understand monetary policy or what a “bubble” is – and just walk around talking like they do. Hey, I can’t see a bubble when its floating around either – which is why I just try to think how it influences monetary policy and financial stability rules “before” passing judgment or opinion on what the Bank should do 😉
Honestly, the four point above are so incredibly fundamental, and so CONSTANTLY ignored, that I’ve had a lot of fun writing this post 😀 . Now to get back to reading about solar power.
The only way a bubble is popped is violently! Has anybody ever deflated a bubble and should we therefore pursue deflation as a tool 😉
So you right in saying that the only recourse is to ensure that the institutions are robust enough to survive the explosion.
Yar, if people want to pop bubbles they really need to say how to do it – and what it means
i think we need to differentiate between a bubble in a specific asset and a bubble in credit creation. The latter is a normal market occurrence and involves actors investing resources into a particular asset, which increases exponentially in price. The resulting bubble and collapse results in a transfer of resources from buyers to sellers. Disruptive yes but not something that really should be an issue. Nick Smith complained vociferously about the outrageous profits on land-banking…but not so much about the outrageous increase in Xero’s share price (of about the same increase).
But bubbles caused by a direct expansion of credit are a different matter, primarily because the whole economic system is financed by credit. We have seen this in the portfolio effect of QE, with commodity and equity markets being blown up (not specifically in bubble territory but with similar characteristics). When housing is the asset class in question, the problem becomes bigger. There is nothing new in this (see Harrison, 2005, Boom, Bust: House Prices, Banking and The Depression of 2010) cycle but it suggests a structural flaw in the financial system. If house prices are driven purely by supply/demand issues, then again, that’s a matter for the actors involved. However, where credit is involved, it becomes a more systemic problem.
That doesn’t mean the RB or anyone else should be trying to “pop” a housing bubble but they need to spend a bit more time focusing on the financial structure and how it drives prices in different bits of the economy.
No I’m still pretty heavily convinced that we don’t need to differentiate bubbles in this way 😉 . Let me explain my view.
If the “bubble in credit markets” is showing up in asset price inflation for certain asset classes, then we are saying people are relatively willing to overpay for a specific asset class – and as a result, as long as we have a situation where banks are adequately capitalized then we are in the exact situation I was describing above. The “bubble” in this situation is driven by expectations.
If the bubble in credit markets is across ALL asset classes, then we again have a transfer across all asset classes from speculators to owners.
Any efficiency loss would arise from over-investment in the asset classes associated with the bubble. As a result, if the bubble is in all asset classes we are really just saying that we are investing too much out of income and consuming too little – this is an interesting line to take, but it does not justify any actions from what I can tell.
Also I can’t say I agree with the line that bubbles are driven by an expansion of credit – surely an “irrational bubble” is due to expectations of capital appreciation, which lead to an increase in demand, which lead to the process of credit creation (due to money being endogenous, and the central bank “setting the price” in the short term). Credit still has to be created by something, the quantity is just not “set” as the old monetarist view – with its focus on full reserve banking – used to place down.
If you reply saying banks can loosen standards etc etc, I agree, and this in turn leads to a appreciation in asset prices (as it is essentially equivalent to a lower interest rate). But this isn’t a “bubble” this is a structural element of the finance industry that leads to capital appreciation – and this is relevant only insofar as there are concerns about systemic risk. As we would both agree on here, this justifies regulation (around things like capital requirements) – but I would argue this is very separate from any discussion of fully defined “bubbles”.
I didn’t say “bubbles are driven by an expansion of credit”. But the ones that are do create a systemic risk. If I could split the hair a bit more, I would argue that “real” bubbles reflect the simple emotions of greed and fear, where an asset appreciates well beyond any justifiable measures. Or in other words it shifts from a yield to a capital return. I buy it because I think I can sell it at a higher price, and not because I think the ongoing return on investment will be worth the risk.
Now, in terms of “credit” bubbles, I take your point that this may simply be a reflection of “real” bubbles but manifested through a demand for new credit with which to speculate with. Thus, the housing bubble is being driven by demand for housing as an asset class AND this is supported by the willingness of banks to create credit to finance this.
IF banks are appropriate capitalised, then fine, but my experience tells me that this hope is rarely realised when the trade reverses. Or as we used to say in the markets, “it’s all about funding, not about P+L” 🙂 So house prices are set by funding issues and not P+L issues (value).
I agree with your final paragraph. To restate my point, I don’t have an issue with bubbles but I do have an issue with systemic financial risk. When those two collide, we generally have a bad outcome 🙂
Hi Raf,
From what I can tell we broadly agree on things here. Most of the disagreement is likely around how we are defining terms.
In my general view, a bubble cannot be “real” in terms of being driven by fundamentals. So the post I’ve popped up here is, in that context, discussing solely bubbles due to “irrational valuations” of the type you’re discussing.
In so far as central bank regulation around capitalisation and systemic risk – this is an issue that has to be looked at in terms of financial stability, indeedy. Our central bank has been on top of that for a while, even working to incorporate this through risk weightings prior to the crisis. It will be interesting hearing it discussed at NZAE this year no doubt.
Another reason I like to seperate these things out is because, if we are genuinely concerned about affordability considerations (namely the cost of a housing service), we should be facing that as a distributional/fairness issue through government policy. Trying to rope the RBNZ in muddies the water and just ensures that, in the end, the fairness issue won’t get the treatment society desires.
A “bubble” does not exist simply because a journalist cannot afford a house in Mount Eden. One of the things people have totally missed is that with interest rates in NZ and around the world at record lows, fair value of real assets is pretty high. Last time I looked rental yields even in the more desirable areas of Auckland were around 4%. Homeowners aren’t completely stupid, they look at the relative merits of renting and owning and rationally prefer the former. If we start to see abundant, well located, cheap and high quality rental stock available in Auckland and Christchurch, we can begin to discuss whether there is a bubble.
Regarding macro stability, I agree, if the percentage of high LVR loans is going up, RBNZ should be asking banks to hold more equity – a lot more. The big 4 Aussie banks are regulated by APRA under a modified Basel II – Basel III framework (i.e. risk weighted assets, with a large element of self-policing). It is blindingly obvious that this is a piss-poor regulatory framework, both in theoretical terms (Hellwig/Admati,Hoenig, Cochrane, Calomiris etc) and in practical ones (GFC, Europe, Citigroup, bailout of Aussie banks in 2008 etc). Rumpelstatskin, an Aussie bank insider who writes under a nom de plume at MacroBusiness, has described how the bank capital requirements in Australia are mathematically flawed and biased to resi mortgages. So there’s a real issue there.
If for some reason it’s not possible to get the banks to hold more equity, then putting more red tape on high LVR loans seems like a reasonable second best solution.
Rental yields are ok, they were a lot better about a year ago 😉 .
The risk-weighted capital requirements do seem a bit too “information heavy”. Especially if we have a Gortonesque view of the way depositors views of risk move between “information insensitive” and “information sensitive” states. My main view is to try and do something about the implicit subsidy associated with borrowing – hence my preference for a deposit tax. We’ll see where we head over time – but like you say high LVR restrictions are likely a stop-gap regulation for now.
Actually I think you will find a certain Journalist used to own a house in Mt Eden then sold up and moved to Wellignton…. probably to be closer to his Labour Party mates…
At least Hickey’s nonsensical drivel gives you an opportunity to (once again) remind people about trade offs.
How do you prick an asset bubble – the same way you do a soap bubble – but changing the dynamic tension on its surface… which will make it go pop… in that scenario the ‘cure’ for the bubble may in fact be a lot worse than than supposed ‘disease’…
Sometimes Hickey needs to STFU.
I’m not sure that is quite the full scope of it. I’d note that Hickey is in no way talking alone, a lot of people are unhappy about the high house prices, and the perceived impact on the affordability of housing. In that context, there is a policy issue, Hickey along with much of society is saying this is causing harm! That is good.
I’m just trying to point out that RBNZ actions to alleviate this harm may not much sense when we dig into them! And as a result, we need to instead dig deeper. On top of this, a bubble in of itself should make housing more affordable – by causing overbuilding and lowering rents – but this isn’t what is happening. This tells us something else is at work here!
Matt, push a forward on financial stability. Why do we want it? Because of economic stability. The rbnz is mandate to do that in the PTA. lets not separate things that are related.
The PTA mentions it here in the communications section:
“In pursuing its price stability objective, the Bank shall
implement monetary policy in a sustainable, consistent and transparent manner,
have regard to the efficiency and soundness of the financial system, and seek to
avoid unnecessary instability in output, interest rates and the exchange
rate.”
Indeed price stability and the soundness of the financial system will have a relationship – but it is the same sort of relationships that fiscal and monetary policy have. They are related to each other, but can be operationally separated (based on a series of different tools). Co-ordination is important, which is why we have the two roles separate but in the same organisation.
I don’t really understand what economic stability is – but you’ve mentioned it, and so have Blanchard and Stiglitz (among others), so it is obviously something I need to get into my head 🙂 . The issue for me is “stability with regards to what”. We have a changing world, with changing technologies and degrees of scarcity. We have a world where people make silly decisions and transfer each other goods and services for nothing. We have a world where sometimes the distribution of opportunity is unfair. I do not disagree that we can see these as policy issues – but they aren’t part of the mandate of a central bank 😉
If economic stability merely means something like NGDP targeting – then it does fall under the monetary policy framework. But bubbles still aren’t a monetary policy issue in that view 😉