- Should we raise interest rates to curb possible asset price bubbles?
- Answers depend on who you ask. "Hard money" people say yes, "soft money" people say no.
- So we'll look at the costs, benefits, and alternatives.
At the most basic level, at one end we have the "soft money" people (most Keynesians, many monetarists, adherents to MMT, the modern monetary theory) who are arguing that markets can fail and the economy can be in a prolonged slump, so we need stabilization policies to correct for that.
At the other end, we have "hard money people" (mostly adherents of Austrian economics and many people from the financial industry) who argue that markets are more or less perfect and always clear and therefore best left alone. Stabilization policies are counterproductive in the Austrian view.
This division is interesting as it leads to different causes for the financial crisis. The hard money people blame this on monetary policy being too lax, causing excessive investment (in houses, consumer durables and business capital).
Soft money people (more especially Keynesians) tend to see the crisis as one of insufficient demand brought about by massive deleverage ($9 trillion was wiped of house values, leading to a rather stark cutback in household spending, producing lower production, employment and capital formation, which decreased demand further).
One could argue that the hard money people (more especially the Austrians) have identified more of a "root cause" of the crisis (too lax monetary policy causing asset bubbles). The Keynesian explanation of the crisis has no natural place for the financial excesses of asset bubbles, only with the consequences of these as they collapse.
The two schools are at opposite ends once again in their prescription of how best to react to the crisis. The Austrians simply argue that markets have to do their "cleansing" work and the excesses have to be liquidated. This invariably involves the write-off of debts and investments, since the latter were financed by too cheap money and were not really viable investments anyway.
The Keynesians argue that the demand insufficiency has to be countered by expansionary fiscal and/or monetary policies. They argue that your income is my spending, and vice-versa. If we all start to cut back, then we're all worse off. The expansionary policy prescription of the Keynesians has the Austrians up in arms. It only prolongs the "cleansing" process and, here we arrive at the present; it risks creating new asset bubbles.
Hard money financial websites like ZeroHedge have a daily barrage of articles arguing that this is exactly what's happening, and even some quarters in the Fed and other policy circles worry whether the special monetary measures are not creating some asset bubbles:
- Janet Yellen, no less, worried about a small-cap bubble
- The German Finance minister Schauble joining in
It has to be said that most Keynesians would have preferred fiscal policy over monetary policy in the aftermath of the financial crisis, but political reasons made this impossible in both the eurozone as well as the US, so monetary policy was the only tool in town, but not their first choice.
However, we do have an interesting experiment that can enlighten policy makers. Remember, Austrians argue that too aggressive monetary policy is the cause of asset bubbles. They often argue that QE is doing more harm than good and interest rates should be increased to liquidate the excesses from the previous bubble and prevent new ones.
For instance, John Mauldin argues:
Alan Greenspan hit the street with The Map and the Territory. Greenspan left Bernanke and Yellen a map, all right, but in many ways the Fed (along with central banks worldwide) proceeded to throw the map away and march off into totally unexplored territory. Under pressure since the Great Recession hit in 2007, they abandoned traditional monetary policy principles in favor of a new direction: print, buy, and hope that growth will follow. If aggressive asset purchases fail to promote growth, Chairman Bernanke and his disciples (soon to be Janet Yellen and the boys) respond by upping the pace.
Well, QE isn't nearly as unprecedented as Mauldin seems to think. Japan used it quite effectively to get out of the slump in the 1930s, and it was in fact Milton Friedman who suggested they should do so again to get out of their deflationary rot at the end of the 1990s. Mauldin went on to argue that:
I can imagine a day in 2016 when the unemployment rate is still well above Janet's NAIRU estimate and the headline inflation rate is above 4 percent. Of course the Fed "models" will still show a big output gap and lots of slack.. Janet will not be bogged down by pesky worries about bubbles or misplaced expectations about inflation. She has a job to do - FILL THE OUTPUT GAP! And if a few asset price jumps or some temporary increases in inflation expectations arise, so be it.
This goes to the heart of the matter. For starters, we think 4% inflation isn't terribly likely (and wouldn't actually be all that bad; one could even argue the contrary) if there is still a lot of slack in the economy (provided the Fed model is correct, as Mauldin speaks of the model, not the economy). But asset bubbles are more likely. Money has to go somewhere. If we would have used fiscal policy, the money would have gone to more useful things, but alas...
Now, in the rest of the article, Mauldin goes off the deep end a bit:
The only question remaining is for how long we can continue to bet the ranch on wildly incontinent monetary policy while deliberately opting to ignore the ongoing disintegration of our economic fabric?
We're not sure about the economic fabric. Growth is not exuberant, but at least it's there, and it would be (mildly) lower without the monetary stimulus. There were significant headwinds from fiscal policy and deleveraging households. But these are topics for another article. What concerns us here is the risk of financial bubbles, which we believe is a real risk.
According to some, bubbles are seen forming in US housing, London housing, Swedish housing, eurozone peripheral bonds, US bonds, US stocks (take your pick). We're not going to discuss the merit of these arguments of whether bubbles are forming; bubbles have the nasty habit of being much clearer after they've burst.
What we are going to discuss is how to prevent bubbles from forming in the first place, and whether interest rates are actually the appropriate instrument for doing that. We don't think so. We think that monetary policy should be firmly used for stabilizing the economy.
Sweden versus Norway
There are two countries which provide something of an interesting experiment, Sweden and Norway. Sweden went the "hard money" way and increased interest rates, first to prevent inflation, but mostly in order to stop house prices from rising further. This under strong protest from its deputy governor Lars Svensson, a leading expert on deflation.
Well, Swedish inflation has now turned negative; that is, the country is in deflation. This is actually remarkable as Sweden isn't a member of the euro, so it can set its own monetary (and fiscal) policy. It's even more remarkable as when policy started tightening, inflation wasn't really a problem anyway.
Once in deflation, it can be rather difficult to get out of it. If you're in doubt, ask the Japanese.
Now, it's an awkward dilemma for monetary policy, you have low (often very low) inflation, but house prices keep on rising, what to do? Is this a matter of Tinbergen's rule: in order to have two policy goals, one should have two instruments?
From Sweden we learn that rising interest rates in order to stop house prices from rising further can backfire on inflation, so it would be helpful to have other policy tools in order to deal with house prices (or, for that matter, other asset prices).
There is actually a remarkable simple one. House prices rise when there is a shortage of houses. One could simply increase the supply, that is, construct more. This would be a much better answer in post-Lehman crashed economies anyway. But there are other things that policy makers can do to stem house prices from exploding.
One could, like Norway has done, curtail mortgage lending by other means than raising interest rates. In the case of Norway, the central bank:
cut the loan-to-value ceiling on mortgages from 90pc to 85pc. It forced the banks to raise to capital buffers further. The Norges Bank has recommended a 1pc counter-cyclical buffer based on its view of what constitutes a safe level of credit growth. [The Telegraph]
These measures basically stopped Norway's house price boom in its tracks, as can be seen from the following figure:
Simple regulation did the trick. There are other possibilities:
- Increase the size of the down payment
- Reduce the maximum mortgage in relation to the execution value of the property and/or income of the prospective owner.
Central banks in New Zealand and other countries introduced stuff like that:
So what is the central bank in New Zealand doing about it? In October, it put a limit on high loan-to-value mortgages. Each bank must see that no more than 10 percent of its new mortgages finance more than 80 percent of a house's value. Before the limit took effect, such mortgages had reached 30 percent of new originations. Such limits on high loan-to-value mortgages are becoming more common internationally; Canada, Israel, Singapore and Sweden are among the countries using them.
More importantly, perhaps:
And they have been found effective "in containing exuberant mortgage loan growth, speculative real estate transactions, and house price accelerations," according a June 2013 IMF review of studies. During downswings, the review found, such measures can reduce "fire-sale dynamics" and loan losses.
Voilà. Let's leave monetary policy for what it is supposed to do, unless we want to create another Sweden. But what about share price or other financial asset bubbles? First of all, these are much less dangerous for the economy. The epic crash of the dot.com bubble in the early 2000s had only a minor and temporary effect on the economy at large.
Secondly, here also alternative policy measures are possible. What about limits to margin debt, bank leverage, capital ratios? We're sure there are quite a few more measures possible here.
We might also bring into memory the fact that we managed to get by without a major asset price bubble from the 1930s to the 1980s, when we started to deregulate financial markets.
The simple question is this, why would main street have to suffer the consequences of higher interest rates when Wall Street is overly exuberant? Especially when there are other effective policy measures possible?