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".