Asset Bubbles and Inflation

Wing Thye Woo sent me a piece on the state of the US and global economy identifying the financial markets as the flashpoint of the problem and asked if I could post it on the Fondad website (you can find it there under “Other Publications”) and circulate it among friends to get feedback. The first thing I did was circulate it among a small group of the Fondad Network and this prompted a debate among a few of them on which I report.

The first one commenting on Wing’s piece was John Williamson. He said that he was in general agreement with Wing’s paper, except that he did not think Wing had made the case for departing from targeting inflation as an objective.

“His argument can equally well be taken,” said John, “to suggest that central banks should examine phenomena like what is happening in asset markets when they assess the implications of current policies for future inflation levels. One might still have times when the criterion suggests the desirability of tightening monetary policy despite a current inflation rate that looks under control. But if in fact the assessment is that asset markets are inflating for rational reasons that cannot be expected to blow up, then surely it is appropriate to let it happen. (And I am not persuaded that one should rule out this possibility by assumption.)”

Wing responded, “I agree totally that it is not always possible to separate asset bubbles from fundamentals-driven asset price increases. I do think, however, that there are some occasions where many reasonable observers could identify bubbles, e.g. the Chinese stock market in 2007. Of course, unanimous agreement is not possible because, if it were possible then there would be no trade in the asset. The Fed's job has just gotten a lot harder now that it finds that procedural simplicity is foolish when hard-to-identify events do occur.”

Then Andrew Sheng came in, commenting, “However difficult that a judgement has to be made, those in position of responsibility are paid to make that judgment. To say that it is difficult and you don’t have theory to help you make that judgment seems to be a cop out. The dilemma is that the cost of making a wrong call has either huge personal consequences or huge social costs.

The issue is whether you think monetary policy is interfering with the free market. If you believe that the market will take care of itself, let’s have no central banks and regulators. But if you have such institutions, someone must make the judgment call when a bubble is forming and when you have to lean against the wind.

What I have never understood is why the margin tool (lowering the loan to value ratio) was never used if there was reluctance to use the interest rate tool. We have seen it all before. When the bubble forms, we all say that this time it’s different. No, it’s not.”

Avinash Persaud added, “It is one thing to say that monetary policy should be mindful of not inflating asset market bubbles and another to say that it should try to prick bubbles. (Geneva Report 2 on Asset markets and central banks tackled this issue well.) While I believe policy as a whole should lean against asset market bubbles (the costs and consequences of not doing so are severe) it is not clear to me that it should be monetary policy that shoulders the burden or that it can do so well.”

Avinash went on, saying, “The level of interest rates required to prick a bubble in its most expansive state would be intolerable for the rest of the economy. (What level of interest rates would be required to prick a bubble based on a belief that property prices rise by at least 10% per year and where investors are 95% leveraged?)

Better then for regulatory policy to carry a large part of this burden.

Indeed, given that the principal purpose of regulation is to avoid systemic crises and the root of most of these crises is a prior asset market bubble, it would seem appropriate for regulatory policy to try to temper the increase in leverage that goes with bubbles. It would also mean that we would be “adding instruments” to macro policy at a time when liberalization and globalization has had the side effect of reducing instruments.

At the heart of most financial crises is leverage, the rise in leverage prior to the crisis based on some confidence that risk has fallen, and the subsequent deleveraging. Charles Goodhart and I have been working on a proposal to add a capital charge based on the rise in the leverage ratio above a pre-determined level. This may act as an added brake and a source of higher capital and reserves that can be used when the crisis hits.”

This prompted Andrew Sheng to say, “Avinash, I couldn’t agree with you more. Irrespective of regulators or central bankers or the division of responsibilities, a key issue is the choice of tools. You have either a price tool (interest rate) or the quantitative tool (leverage or credit supply). Hence, if you don’t want to use one, you may have to use the other.

The central bank is in charge of macro tools, but one of our dilemmas is that there is no accepted measure of macro-leverage. So, if you add the philosophy of minimally interferring with the market, then you are unlikely to use the leverage tool. Add in the confusion of responsibility whether the central bank is both a regulator and monetary policy agency, then the specialist regulators are waiting for signals from the central bank and individually in silos, they may not be able to stop the bubble forming.

Hence, you have to have a unified view whether a bubble is forming and someone has to take a lead in that judgement and decision. This is a matter of will, the willingness to make a judgment call and be evaluated by the market whether you avoided the bubble or not. What you and Charles have suggested is the micro-regulatory tool to ensure that individual institutions fine-tune their risk management. This is very useful but as we have learnt, these tools do not prevent greed of bankers from making all kinds of excuses, such as accounting and Basle rules, not to make the precautionary measures against taking on excessive leverage. The best rules do not stop bad behaviour. Strict and clear enforcement does.

Ultimately, it is the greed factor and the incentive structures, particularly personal interests, that drive the bubble and leverage forward. Central bankers have a fiduciary duty to somehow stop the ordinary crowd from allowing themselves to go mad. From time immemorial, leaders have to make personal sacrifices for the public good, this includes being blamed for taking or not taking key decisions. C’est la vie.”

Then Stephany Griffith-Jones commented, “I totally agree with Avinash. Particularly for developing countries it is crucial of course to include exchange rates as a key asset price.”

John Williamson rejoined the debate and said, “Bubbles are by definition movements in prices that cannot be explained by fundamentals like interest rates, so I agree hat it would be foolish to rely on monetary policy pricking bubbles. That might easily involve intolerable strains on the rest of the economy. I think this consideration adds a reason as to why monetary policy should not follow the Woo formula of targeting a price level that includes asset prices, but that it leaves intact my version which says that the implications of any bubbles for future inflation should be taken on board by the central bank in formulating its monetary policy.

Where I do agree with the subsequent discussion is that regulation and not monetary policy should bear the main burden of curbing bubbles. Without having read the Goodhart-Persaud paper, it seems to me that their proposal is very much along the right lines and not primarily directed at microeconomic factors.”

Stephany's second comment was, “As I wrote, I strongly agree with Avinash and now John on the centrality of regulation to limit the increases in asset prices. It is very encouraging to see that so senior a policy maker like Mishkin is moving along similar lines that several of us have been developing for some time, (as reflected in today's FT, of 17 May, where he is quoted as arguing in favour of countercyclical regulation). It would be great for this group to come up with specific proposals on this aspect, building on the Goodhart-Persaud FT article, and their other work, on John's book, and on the work that José Antonio and I have done on countercyclical regulation, on the Spanish provisioning system, etc.

I think a key precondition for doing this effectively is far more complete information for regulators on what is happening in financial and banking markets, e.g. derivatives, so they can see where excessive TOTAL leverage is developing, including in areas with no capital requirements. Ideas like that of Soros to bring OTC derivatives on the exchanges- could be helpful to identify total leverage.”

The discussion goes on. Comments are welcome. You can also send them to my email address, to be found on the Fondad website under "Contact".

Dogmatic thinking

I don't like dogmatic thinking and dogmatic statements, but in several posts I have spoken about ministers of finance and central bank presidents as if they would be dogmatic thinkers by definition. Or, at least, that's the impression you may have gotten.

However, I'd like to stress that I do not think all ministers of finance and all presidents of central banks or all managing directors of the IMF, are dogmatic in their thinking, writing and speaking. Or that they are always dogmatic. How would I dare to think that!

I have high esteem for several (former) ministers of finance and central bank presidents (or their deputies) and I am happy that a few of them "belong" to the FONDAD international network. I don't need to mention their names, most of them you can find in the list of the FONDAD Network on our website.

Let me make one exception: Bill White (his official name is White, William). I have high esteem for his thinking and his commitment. I remember vividly how he shared with me many, many years ago, long before the subprime and credit crisis emerged, his concern about US credit markets. At the time, I understood that his public statements were more careful and less articulate, and I still understand that. For many years, I have also been more careful and less articulate than before I created FONDAD.

To finish this brief thought, I think you have to take into account certain roles you have to play. Being careful in your words does not mean you are a conformist. It may just mean that you apply a bit of self-censorship, for certain reasons. Whether those reasons are good, depends on your own assessment. Others have nothing to do with that -- unless you are interested in hearing their opinion.

A passionate view

There is one thing I'd like to add to the previous post, not an extremely important thing for those who like "pure" economic arguments, but a significant thing for those who like to look beyond numbers.

In the previous post, I only highlighted the gist of Avinash Persaud's article, not the flavour. I mean, he wrote the article in a personal way, with a personal voice, and I not only like that but also think it is significant when you make an argument. Let me illustrate my point by quoting the first paragraph of Avinash’s article:

"Flash back 10 years to May 1998. The Asian financial crisis is unfolding. I am sitting on the J.P. Morgan dealing floor in Singapore. My trip to Jakarta has been cancelled because of rioting. Students have been killed and women raped. Regional currencies are in free fall. Local equity markets are imploding. Credit-rating agencies are 'helpfully' responding by slashing credit ratings. The region's vaunted political and economic stability is collapsing before my eyes. On the Morgan dealing floor, we can't tear ourselves away from the electronic screens transmitting the bloodbath tick by tick. I feel the primordial pull and guilt of passersby to get a closer look at a ghoulish car accident."

In my view, writing style is more than style. It reveals emotions. Thinking about (financial) globalisation requires a passionate and a dispassionate view. The one without the other reduces economics to either numbers – in the case of a purely dispassionate view – or emotions.

Economics is not about numbers but about people. In another post, I'll say something about the need for a passionate view.

The photograph of the man on his chair comes from "U.S. Camera 1939", Edited by T.J. Maloney, and published by William Morrow & Company, New York.

Bad economics

I like sound analysis and sound reasoning. I dislike "sound economic policies" as they usually refer to dogmas.

I like discussions in which good arguments are explained if needed, and I dislike discussions in which good arguments are dismissed (usually by economists vested with power) without considering them seriously.

I like simplicity where possible, and I dislike simplicity when complex analysis is needed.

With this, I would like to introduce Avinash Persaud, whom I see as a sound thinker whose thoughts should be taken more seriously by policymakers.

Avinash Persaud has written an article, “Financial Regulation: Sending the Herd over the Cliff. Again”, that he sent to me saying it will appear in the June 2008 issue of the IMF's Finance & Development. Its basic argument is that risk models of banks create a false sense of safety and make crises worse when they emerge. In 1998, when the Asian financial crisis unfolded, and Avinash still worked with J.P. Morgan, he “learned first hand that whereas risk-sensitive systems may help banks manage their risk during quiet times, they are not crisis-prevention measures: they make crises worse.”

In 1999, Avinash wrote a Prize winning essay, “Sending the Herd off the Cliff Edge: The Disturbing Interaction of Herding Behaviour and Market-Sensitive Risk Management Practices”, and noticed it was dismissed by regulators as “too theoretical or extreme”.

In his recent article, Avinash disagrees with the regulators’ charm with market risk models that banks use and their proposal to incorporate these models in the new rules of Basel II.. “The reason we regulate markets over and above normal corporate law,” says Avinash, “is that markets fail from time to time, with devastating systemic consequences. If the purpose of regulation is to avoid market failures, we cannot then use risk models that rely on market prices as the instruments of financial regulation. (…) Risk sensitivity as a regulatory principle sounds sensible only until you think about it.”

Avinash stresses that market failure relates to the economic cycle. Banks and markets underestimate risk in the up cycle and overestimate risk in the down cycle. “In an up cycle, market participants always see some new paradigm that tells them the cycle is dead or that it’s ‘different’ this time. (…) At the top of a boom, the risk models prescribed in Pillar 1 of Basel II, whether using market prices or the ratings of credit-rating agencies, will be telling banks that they are running less risk and are better capitalized than they will in fact turn out to be when the credit cycle turns.”

In Avinash’s view, Basel II is bad economics. “It tries to use market prices to predict market failures and destroys the natural, liquidity-inducing diversity in risk assessments. What it ends up doing is precisely what regulation should be designed to avoid: acting procyclically.”