What central banks should do to deal with bubbles

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July 13, 2014 2:17 pm
What central banks should do to deal with bubbles
Wolfgang MunchauBy Wolfgang Münchau
It is a mistake to view macroprudential regulation as a potent independent policy tool
©Bloomberg
The world has conducted two controlled experiments on how to fight financial bubbles in the past decade. Both failed.
The first was to ignore the bubble and to mop up later. The idea seemed plausible to a lot of people. But it was based on the false premise that the costs of mopping up would be bearable.
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The second experiment has just concluded in Sweden, also with calamitous results. There, the central bank did the exact opposite. It had previously raised interest rates to rein in a domestic housing bubble. In doing so, it generated deflation and raised unemployment. It recently corrected that policy error by cutting the interest rate back to 0.25 per cent.
These two experiments present the opposite ends of our thinking: either ignore bubbles or ignore everything else. What should central banks do?
The consensus view is that they should rely on macroprudential regulation. The Hong Kong Monetary Authority, for example, imposed restrictions on loan-to-value ratios for mortgages. The Bank of England recently placed caps on mortgages with very high income multiples.
Central bankers love macroprudential tools because they are in thrall to an old idea that is simultaneously true and useless. The Tinbergen rule, named after a Dutch economist, states that you need one policy instrument for each policy target. If you have two targets – price stability and financial stability – you need two instruments. Monetary policy deals with prices, macroprudential regulation takes care of bubbles. Problem solved.
Or is it? For a start, the instruments are not entirely separate. Monetary policy affects not only retail prices but also the prices of financial assets. If a central bank commits to keeping interest rates at zero for the foreseeable future, it sets a benchmark for the price of risk-free securities directly and other securities indirectly.
There is also a more fundamental problem. Consider Spain’s housing bubble. The country has an above- average share of brilliant economists and bankers yet hardly any of them expressed concern about pre-2007 house prices. So what would macroprudential supervision have accomplished in those years? Even if our hypothetical macroprudential regulators had correctly identified the risks, they would still have focused on the banking sector. Yet the real tragedy of post-bubble Spain occurred in the household sector. The country’s conservative bankruptcy rules meant that many mortgage holders have been saddled with huge debts for the rest of their lives. Macroprudential regulation might have saved the banks but it would not have saved Spain.
Central bankers are fooling themselves if they think macroprudential regulation is a potent independent monetary policy tool. It is a useful supplementary tool, nothing more, nothing less.
Our best hope lies in a unified framework. Unfortunately, the workhorse models used in mainstream economics do not have a concept of finance. Default cannot happen in these models because their fundamental building block is the “representative agent”, jargon for “your average Joe”. But the average Joe cannot simultaneously default and be defaulted on. You need two Joes for that – none of them is average. Specifically, you need a financial sector in those models, one that includes what we have seen in the past decade – default, credit crunches, rent-seeking, extortion of governments, antisocial behaviour, unethical behaviour, criminal behaviour – to mention just a few.
The great James Tobin, another Nobel-prize winning economist, produced a model with an explicit role for asset markets as long ago as 1969. But rather than building on his work, the economic mainstream rode off in a different direction. The financial crisis gave rise to new approaches but they are still not mainstream. Central banks do not actually use them.
I have been intrigued by some pioneering work by Markus Brunnermeier and Yuliy Sannikov at Princeton, who constructed a model in which the world has two states: one in which banks lend freely and one in which they do not. The policy prescriptions of this model are not fundamentally different from what central banks have done recently. But with the possibility of a future credit crunch integrated into the model, interest rate policy cannot be blind to asset price developments. Such a model would suggest an earlier rise in interest rates in the UK, for example, compared with standard models. For the eurozone, the model would justify aggressive policy easing because a fall in the rate of inflation or outright deflation would harm financial balance sheets and add to instability.
There are several competing approaches. Modern monetarists focus on money, as opposed to credit, as the driving force. But despite their huge differences, both ideological and practical, none of them supports the experiment that just failed in Sweden or the one that failed 10 years ago. And none is particularly keen on macroprudential regulation.
munchau@eurointelligence.com

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http://www.businesstimes.com.sg/premium/...n-20140812

PUBLISHED AUGUST 12, 2014
Easy money cannot be new norm: MAS' Menon

BYANTHONY ROWLEYIN TOKYOPRINT

EASY monetary conditions have had a global impact since the US Federal Reserve and other leading central banks adopted quantitative-easing policies, but this must not be taken as the "new normal" state of affairs, Monetary Authority of Singapore managing director Ravi Menon has warned - PHOTO: BLOOMBERG
EASY monetary conditions have had a global impact since the US Federal Reserve and other leading central banks adopted quantitative-easing policies, but this must not be taken as the "new normal" state of affairs, Monetary Authority of Singapore managing director Ravi Menon has warned.
He said in an interview with the journal Central Banking published yesterday that policy has to eventually normalise, and that this should be done as soon as practicable so that "people do not think easy money is the new state of affairs and make investment decisions on that basis".
Mr Menon, who used to be permanent secretary at the Ministry of Trade & Industry and deputy secretary in Singapore's Ministry of Finance, also said in the interview that China was at "a major inflection point", and that its major restructuring and reform effort would not be easy to pull off.
"The sooner we see a normalisation of monetary conditions globally, the better for us here in Asia and in emerging economies," he told the UK-based publication, which circulates widely within the financial community.
"The spillover effects of unconventional monetary policies are not insignificant," he said. "Volatility in capital flows, pressures in asset markets, a general increase in financial stability risks and a flattening of the yield curve that distorts investment decisions are not trivial consequences."
Abnormally low interest rates have caused longer-term structural challenges for financial market participants such as pension funds.
This was not just about macroeconomics, he argued. "There are broader economic and social consequences from low interest rates, not to mention some of the distributional effects that these unconventional monetary policies have had."
Most central bank governors in emerging economies want to see monetary policy normalised as soon as practicable, he noted, but stressed that such action needs to take place in an orderly fashion so as not to unsettle markets, and to give economies time to adjust.
Mr Menon said the US Fed has done a "reasonably good job" in communicating its monetary policy intentions.
He noted that it was sending out two messages: One was that policy has to eventually normalise - an important message, so that people do not think this is the new state of affairs and make investment decisions based on this.
The other message is that normalisation is not coming too soon, and that the pace of this would be dependent on the state of the US economy.
Mr Menon said in the interview that there was no recipe or textbook answer on how to do this and little certainty on how markets will respond to the normalisation of interest rates.
"Some economies, which may not have been as cautious as they should have been during the boom years of easy money, may have a tougher time negotiating the exit of these policies."
On China's reform effort, he described it as being "unprecedented in scale and ambition" and difficult to accomplish, especially since China is undertaking it at the time when the growth momentum is slowing.
The key challenge facing Chinese policy-makers is to pull off an orderly restructuring, he said.
"Growth has already moderated from more than 10 per cent on average to about 7 to 8 per cent. Can they sustain the reform or even accelerate the reform effort, without too big a cost to growth and employment?
"The primary concern of Chinese policy-makers is that there is a large number of people coming into the work force each year and they do not want to see a big increase in unemployment."
China can probably deal with problems in its "shadow banking" sector, but deflating China's real estate "bubble" may prove more difficult as tackling the issue is more "art than science", he said.
"You have to deflate it gently so it does not create disruption in the real economy. You cannot jam on the brakes and risk derailing the economy."

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Bubble-bursting precursors reminiscent of '94 bond crash
Clancy Yeates
511 words
12 Sep 2014
The Australian Financial Review
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One of Australia's most senior bankers has predicted global financial markets could face a "meaningful" correction similar to the 1994 bond crash, because aggressive monetary stimulus is inflating asset bubbles.

Rob Whitfield, the chief executive of Westpac's institutional bank, on ­Thursday warned that bubbles were forming as global investors took on more risk in search of higher returns.

But he stressed that this did not mean the world faced another ­global financial crisis, because key ­vulnerabilities had been addressed and banks and economies were better able to cope with shocks. Speaking in Tianjin in China, Mr Whitfield said central bank moves to stimulate growth had created "a wall of liquidity," which had in turn triggered a global hunt for yield reminiscent of conditions before the 1994 bond crash. "I predict a future market correction; perhaps even a meaningful one," he said in an organised debate with other executives and experts at the World Economic Forum. "Credit spreads are narrow, forcing a move by many into higher risk assets; junk bond yields are at all-time lows," he said. "Asset bubbles are emerging – US share markets have posted successive record highs in recent times despite tapering and mixed economic results."

"It is my view that the current ­environment is ripe for a market ­correction that both looks and feels like what we experienced in 1994," Mr Whitfield said.

In the 1994 bond crash, US Treasury bond yields surged suddenly after being pushed down by recession and low inflation.Bond yields and prices move inversely.Raising bond yields could damage

When the US Federal Reserve responded by raising rates, yields on bonds around the world jumped, ­pushing up borrowing costs. If this occurred today, there is a risk it could damage the global economy.

Mr Whitfield highlighted the ­similarities between conditions today and those of 1994. Historically, ­he said asset bubbles had "largely arisen during periods of ultra-accommodative monetary policy combined with sustained periods of low interest rates and an ever-increasing supply of money – sound familiar?"

He did not specify how far he believed asset prices might fall, but "correction" generally refers to a fall of 10 per cent or more."

Central banks faced a challenging task in trying to "normalise" conditions, he said, because keeping rates low ­created risks but moving interest rates too quickly could also damage the ­economy. If moves to raise rates did harm growth, he said it would likely result in a "normal," or possibly a "meaningful" correction, with prices falling to more sustainable levels.

He made the comments as part of a debate with several other finance ­executives and experts on whether the world inevitably faced another global financial crisis. Mr Whitfield argued that a GFC that froze credit markets was not inevitable, because regulators were more prepared, and banks faced tougher supervision and scrutiny.Surge warnings

"The failures that perpetuated the recent crisis today no longer exist and our ability to withstand serious shocks is much stronger," he said.


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Investors taking on too much risk, central bank chiefs warn
THE AUSTRALIAN SEPTEMBER 19, 2014 12:00AM

David Uren

Economics Editor
Canberra

GLOBAL central bank chiefs meeting in Cairns have warned that their efforts to make banking safer have resulted in investors fleeing to less regulated and higher risk markets, posing a danger to the world financial system.

They said the exceptionally low interest rates around the world were leading investors to search for higher returns than were offered by the banks.

“There are increasing signs of complacency about risks in financial markets,” the meeting of the Financial Stability Board concluded.

The board, which represents the central banks and finance ministries of 28 nations, said asset prices were high and volatility extremely low across an increasing number of markets, increasing the risk of a “sharp reversal”.

Concerns have been focused by the prospect of the US Federal Reserve raising rates next year.

Although the Fed’s meeting this week said rates would remain close to zero for “a considerable time” after the bank stopped its bond-buying program (expected next month), it indicated that rates would then rise more rapidly than most expected.

It foreshadowed that US rates would reach between 1.25 and 1.5 per cent by the end of next year. Central banks are worried that financial markets will become turbulent in the early months of 2015 in anticipation of the first rate rise, and that this could expose investments made at a time of suppressed volatility over the past two years.

“While market forces and regulatory reforms since the crisis have reduced leverage in the banking system, leverage has picked up in other parts of the financial system, including in corporate debt markets,” the FSB said in a formal release following a plenary session of all members.

Corporate debt has been rising in a number of markets, including the US, supported by share buybacks.

The FSB’s major concern is capital markets and the managed funds that trade them.

It believes investors are taking excessive credit risk, liquidity risk and term risk.

They are investing in assets bringing far too low a return given the uncertain quality in the underlying asset and they are investing in the belief that they can sell their asset at any time. Those investing in long-term bonds are getting too little premium. The FSB emphasised the mispricing of liquidity risk.

“Pressures on market liquidity could exacerbate downward price dynamics and market dislocations during a price fall,” the FSB said.

Regulators believe that although some of the biggest retail investments through vehicles like the US money market funds are not leveraged, the effect of a “rush for the exit” could magnify price movements and generate market disruption in the same way that leverage does.

Regulators have referred to the “liquidity illusion” that has ­encouraged investors to put their money into funds, believing they can be withdrawn at any time like a bank deposit.

The FSB, which was set up in the wake of the global financial crisis, has been focusing its efforts on devising regulation to reduce the likelihood of any repetition in the banking system.

Some regulators believe the increased regulation of banks has contributed to the increased liquidity risk in capital markets, as banks have been required to cut back their market-making ­activities.

However, others say the experience of 2008 and 2009 was that when markets are disrupted, the banks stopped making ­markets anyway. The board concluded yesterday that it had made considerable progress with the banks.

“The core of the financial system continues to strengthen, with overall improvements in bank capital and liquidity, including in the euro area,” it said.

A new round of “stress testing” of Europe’s banks is under way at the moment.

However, the FSB com­mented that “authorities are stepping up their monitoring of the migration of risks to less regulated parts of the financial system”.

Emerging country members of the FSB have been reinforcing their capital controls to reduce the risk that their economies could be destabilised by volatile capital flows and market dis­ruption.

Not all members of the FSB agree that financial markets face imminent danger.

However, it is an organisation with the express purpose of doing what it can to enhance financial stability.

The meeting, held at the Cairns Shangri-La Hotel, involved about 70 officials from the 28 nations around the table.

Economies with larger banking sectors such as Britain, the US and China get three delegates, while smaller economies like Australia get two.

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Haven't we seen the warnings before?

Baker Philip Baker
737 words
20 Sep 2014
The Australian Financial Review
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The Dow Jones and S&P 500 at fresh record highs and one of the world's largest ever initial public offerings snapped up at the top end of expectations – Alibaba priced at $US68 – are surely signs of froth and bubble on Wall Street.

On some measures, shares in the US look as expensive as they did in 1901, 1929, 1966 and 2007.

And each time there was a savage sell-off from those well-known periods, the following five years ended up being very tough ones for investors. But what if this cycle takes longer to play out?

Can the bull market in shares keep going despite valuations looking toppy?

The outlook for the global economy isn't upbeat but it's not a doomsday scenario either.

It might just take a few more years than normal to get back to trend growth.

If traders and fund managers can keep their animal spirits in check then hopefully the imbalances and risk taking might take longer to build up.

But history says this just can't happen and usually it gets so out of control that it does finish with a bust and a bang.

It's one reason the benchmark US government 10-year bond yield is now closer to 2.6 per cent than the 12-month low of 2.33 per cent it was at the beginning of September.

The bond rate is a key to this recovery and if it continues to rise it will, very quickly, reach a level the US economy won't be able to withstand.

The record-low bond yield has also been a driver away from fixed income and into shares while analysts also plug that risk-free rate into their models. The lower the bond yield the more attractive shares can be valued but it changes as they rise.

Getting back to current sharemarket valuations, there are two measures that suggest Wall Street is getting to extreme levels.

One well-known theory about valuations measures the market capitalisation of a sharemarket against the total value of the goods and services of its economy.

Stocks are deemed to be expensive when the ratio is more than 100 per cent.

It's a measure Warren Buffett uses a lot.

At the moment the ratio is about 125 per cent and that compares to 115 per cent in 2007, 87 per cent in 1966 and 153 per cent in 2000 when the tech bubble was still inflating.

Clime Asset Management also point out Buffett's cash holdings is quite high right now, reflecting his wariness towards the sharemarket.

At $US55 billion ($61 billion), Buffett has never before held this high amount of cash. Normally he has around $US25 billion sitting in the bank just in case there is a large insurance claim.

In 2004 and through to early 2007 he had around $US40 billion but in 2009 when stocks were getting slammed his cash level was reducing as he started buying.

That's because everyone else was selling.

He had less than $US25 billion in 2009, the low point for Wall Street as investors bailed out of stocks, but as the bull market began in 2012, he has added to his cash holdings, selling into the strength, and now holds more than ever.

The other valuation measure is the one used by Benjamin Graham and David Dodd where they believe it's better to focus on earnings over a period of time, rather than at the end of a financial year or some other designated date, so it takes into account the ups and downs for businesses through an economic cycle.

Nobel Prize winning economist Robert Shiller also took this line of thinking into account when he came up with his CAPE valuation measure.

Or the "cyclically adjusted price to earnings" ratio.

On that measure, the CAPE was at similar levels today as it was in 1901, 1929, 1966 and 2007.

According to Clime, these periods were followed by poor outcomes for investors with five-year compound annual growth rates of 3.1 per cent, minus 24 per cent, minus 3.2 per cent and minus 1 per cent.

For history not to repeat itself investors need to see better earnings from companies or interest rates falling further, which doesn't look likely at this stage.


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[Temperament]

That's why if someone tell you "this time is different", it really means it's time for you to do something "the same".

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Central banks now look to expand their empires

Maximilian Walsh
909 words
25 Sep 2014
The Australian Financial Review
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English
Copyright 2014. Fairfax Media Management Pty Limited.
Maximilian Walsh

Bubble fears Central banks conquered inflation in the 1980s and have managed the recovery from the GFC. Now some want more tools to control excess borrowing. Maximilian Walsh

"Having experienced the old system under the Fraser government and having watched and listened as Paul Keating boasted of having the Reserve Bank in his pocket, I thought the change (of giving the Reserve independent authority to set interest rates) made a lot of sense."

John Howard, Lazarus Rising.

While proud to have presided in 1996 over the concept of Reserve Bank independence, former prime minister John Howard was not entirely satisfied with what followed. Writing about the 2007 election, which he lost, Howard noted the Reserve Bank had used its independence to run tighter monetary policy than many other central banks.

With studied understatement he observed: "Those interest rate adjustments were not always politically palatable".

It will be interesting to hear his current views, as the emerging debate so-called macroprudential tools be developed and deployed across financial systems to provide an early warning of potential systemic crisis.

Our present domestic policy challenge is to cool down an overheated housing market. This has to be achieved without resorting to lifting interest rates.

Tighter rates policy would deliver an instant and unwanted appreciation of the Australian dollar – courtesy of the global carry trade – before it would have any impact on the housing market.

Macroprudential policy, its advocates point out, could address the problem by capping the loan-to-valuation ratio (LVR) for housing mortgages.

By specifically targeting such transactions in this fashion, the official short-term interest rate would not be affected. Fine-tuning could even define eligible housing transactions by geography or other discrete criteria. The cap could be adjusted over the cycle, much the way it is now done with monetary policy.A fad

Sounds simple. Luci Ellis, head of the Financial Stability Department at the RBA, has pointed to the complexity involved even in this, quite basic, macroprudential exercise.

The first issue is that it would only be relevant for home mortgages. Business lending can be structured around such restrictions.

Secondly, the cap would have to be set very low to be binding on existing home buyers who are trading up. First home buyers would be squeezed out.

Thirdly, the cap would not prevent boom-bust cycles in housing prices. The evidence from overseas is caps limit the increase in arrears rates that occur when a bust comes.

Finally, focusing too much attention on the LVR would be a mistake. There are many other dimensions of lending standards beyond LVRs.

A borrower's ability to repay is more important than the collateral.

Lenders also need to think about how certain they are of the valuation used in the LVR. As Ellis has pointed out: "One of the things that went wrong in the United States during the boom was that the valuations behind the lending decisions were often flawed or even fraudulent."

Such concerns have not dissuaded other countries from setting up macroprudential supervisors and regulators. The US now has a Financial Stability Oversight Council. The UK has its Financial Policy Committee.

Since 2010 Chinese regulators have lowered the LVR ceiling to 70 per cent for first-time buyers, with even lower limits applied in cities with "excessively fast" price appreciation. Similar measures have been rolled out in Hong Kong, India, Indonesia, South Korea, Malaysia, Singapore and Thailand.

The much-greater interventionist role across Asian economies in the credit allocation process is, to some extent, a legacy of the Asian contagion crisis in 1997-98. Canada and some Scandinavian countries have also gone down the macroprudential path of additional regulation. Australia is not for turning on the issue. Reserve Bank Governor, Glenn Stevens, has dismissed the macroprudential push as "a fad".The one-eyed man

But as the Australian dollar has obstinately refused to follow our terms of trade down, the macroprudential case has been attracting increasing attention.

One Reserve Bank board member, John Edwards, has publicly endorsed the idea more extensive macroprudential regulations than currently available to existing regulators cannot be ruled out down the track. His observations carry some unusual weight in that Edwards was an economic advisor in Keating's prime ministerial office. Labor Treasurer Wayne Swan appointed him to the Reserve Bank board. Within Labor's circles, where economists are rarely encountered these days, Edwards is the one-eyed man in the land of the blind. As such, his words and judgements carry considerable weight. Add Howard's rather jaundiced view of the Reserve Bank's exercise of its independence in a politically unpalatable fashion and Stevens's dismissive view, it would not take much from disparate forces for the pro-macroprudential snowball to begin rolling. The main proponents of macroprudential policy implementation (outside Australia) have been the central banks. Two British academics from the London School of Economics, Jeffrey Chwieroth and Jon Danielsson, have been looking at the political challenges of the macroprudential push and they point out that its agenda is hard to disagree with. After all, independent central banks tamed inflation in the 1980s and have been in the front line in deploying macroprudential policies through the global financial crisis. Now they want to expand their empires.

Maximilian Walsh is deputy chairman of Dixon Advisory and a former editor and managing editor of The Australian Financial Review.


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