Central banks and asset bubbles

[Ginger Yellow]

It seems the hot topic at the moment is whether central banks should intervene to deflate asset bubbles before they burst. It was the focus of much debate at the conference I was at last week, with proponents arguing that you need someone like the Fed to "take the punch bowl away just as the party is warming up", because collective action problems mean the market can't do it itself. Naysayers argue that interest rates are too blunt a tool and that bubbles are very hard to spot before they burst. The first point is fair enough, but the second seems wrong to me. Sure, some burst bubbles come out of the blue, but others are very easy to spot. Greenspan famously called the tech bubble but didn't do anything about it, while the recent housing bubble was more obvious than a blue whale trying to pass itself off as a dolphin. I mean, how could you look at this chart and not see a dangerous bubble?

[ursus arctos]

Central banks and asset bubbles

Indeed, the second bit is bollocks, while the first bit is quite true (though doesn't absolve the banks completely).

Were people talking about the Nordic intervention to support Iceland? I find that an interesting precedent (though I'm not sure it would ever be applied outside of the area).

Is that graph for the UK or a wider geographic area?

[Ginger Yellow]

Central banks and asset bubbles

That's US, although you could easily come up with a similarly scary graph for the UK based on price-to-income ratios.

[caja-dglh]

Central banks and asset bubbles

I think it is pretty clear that the US bubble on house prices was assisted by the low interest rates following the dotcom bubble, though ignores that the (possibly more damaging cuts) were as a reaction to the terrorist attacks in 2001 where the US moved to cut to near zero in reaction.

The other problem in the US is the huge tax benefit you get on interest payments on debt, encouraging the over-leveraging of housing debt as a means to actually increase your buying power. Though the UK bubble near mirrors the US position, I can't help but feel the tax incentive that exists in the US made the bubble more aggressive, and the fall out as a consequence more severe (not even accounting for the CDO, CDO squared and other devices built on the back of it to build returns).

Increased regulation will always cause a stir, as the notion of moving against the free market seems reactionary to adverse circumstances that caused the two bubbles. Rate changes on the dotcom bubble would have had little effect as the returns believed on the stocks was so high - only on the housing bubble may it have had a reasoned effect (and the circumstances that incubated that bubble mentioned above were unusual).

I always thought increasing rates to avoid overheating was part of the natural drivers of monetary policy, though both the UK and US try their hardest to remove house prices from their inflation figures as it is "misleading", keeping only a secondary eye on the housing figures. Maybe this is where a policy change may give some reasonable control. The problem is that the next bubble is unlikely to be in housing - a market that has effects that are so dispersed across the population. Which leads me to believe most consideration now is a post-mortem, and will unlikely help in the next bubble cycle (oil? food?).

Not particularly hopeful, I know.

[Anton Gramscescu]

Central banks and asset bubbles

Two points:

1) Long-term re-adjustments of prices do happen. check that graph GY published. There was a step-jump in house prices in the 40s. Was that a bubble? No, it was a jump to a new plateau of stability. In relative terms, the more recent jump in house prices only exceeded the 40s in scale in the last two years or so. Yes, we all knew there was a run-up in prices. But not an unprecedented one, and one of the main precedents did not end in tears. And in those last two years, people didn't want to "take away the punchbowl" (i.e. raise interest rates) because of weaknesses in other areas of the economy.

2) Which brings us to point 2. How do you head off a bubble in one class of assets without screwing the rest of the economy, too? This is a touchy one. I think some of the people bitching about Greenspan are missing this point. Not all of "greenspan's bubble" was a bubble, either. I believe he made his "irrational exuberance" remarks when dow was about 6500. Despite six years having gone by since the end of the tech bubble, dow is still over 10,000. Which means maybe it wasn't *all* irrational.

Which is not to absolve central bankers of their part in the current mess. I'm not so sure about the need for central bankers to take away the punchbowl - but Greenspan (and more recently Bernanke) have acted as if it is the job of central bankers to beat the shit out of anyone *else* threatening to take away the punchbowl. Stockmarket losses threatening returns? better lower interest rates! House prices coming down? Better lower interest rates. Every signal they send seems to state that regardless of the state of the real economy, the job of the Fed is to eliminate any possibility of loss on returns to capital. Which is asinine.

Anyways, as a young(ish) potential home buyer, I don't see a housing crisis at all. I see a housing opportunity. Why the central banks should be intervening in the economy to ensure that the market *not* give a break to young people in the housing market is mystifying to me.

[Stumpy Pepys]

Central banks and asset bubbles

I can imagine measures to try and curtail a house price bubble — bigger deposits for mortgages for example — but what kind of measures are there to prevent a stock market bubble?

[Ginger Yellow]

Central banks and asset bubbles

Well given how much the stock market is moved by rate decisions, that's probably the best use for such a tool. I don't think rates are the way to control asset bubbles in general, though, if that's what you're going to do. People have been talking a lot about modifying Basel II to make the capital adequacy rules countercyclical. National supervisors could use their discretionary powers to target specific sectors.

In relative terms, the more recent jump in house prices only exceeded the 40s in scale in the last two years or so. Yes, we all knew there was a run-up in prices. But not an unprecedented one, and one of the main precedents did not end in tears

That's not entirely true. I haven't been able to find the chart yet, but Brad DeLong posted one before the bubble burst showing specifically new build house prices, which were three times higher than ever in recorded history. Previously they had stayed within a clearly defined range. Moreover, even in the chart that I linked, the price-to-rental income ratio reached historic highs quite early in the boom. Anecdotally, there have been plenty of stories of buy-to-let borrowers who couldn't meet mortgage payments even with a tenant.

[anton pulisov]

Central banks and asset bubbles

The other problem in the US is the huge tax benefit you get on interest payments on debt

Yeah, they have the same thing in Holland, where interest payments on mortgages are tax deductible. It was supposed to make it easier for people to buy houses, but all it has done is make Dutch houses some of the most expensive in Europe, which makes it more difficult for starters to buy a home.

[Stumpy Pepys]

Central banks and asset bubbles

People have been talking a lot about modifying Basel II to make the capital adequacy rules countercyclical.

Ah! It all makes sense now.

[NHH]

Central banks and asset bubbles

dglh wrote:

The other problem in the US is the huge tax benefit you get on interest payments on debt, encouraging the over-leveraging of housing debt as a means to actually increase your buying power...

And yet...

Increased regulation will always cause a stir, as the notion of moving against the free market seems reactionary to adverse circumstances that caused the two bubbles.

That's some free market there. As in a market in which some people get things for free.

[Anton Gramscescu]

Central banks and asset bubbles

I'd be interested in the De Long piece, but price-rent ratios being historically high doesn;t necessarily mean anything. Check out that period in the 40s on the graph. At any point in that run-up, one could have made the same argument that price-rent ratios were at "an all-time high". And yet, clearly, that wasn't a bubble.

[Ginger Yellow]

Central banks and asset bubbles

Well, there was quite a severe correction at the end of it. And as I say, if you can't afford to pay your mortgage with a tenant paying market rents, then clearly you've paid more than the house is worth. I doubt that was true in the 40s.

[Ibn Pickthall]

Central banks and asset bubbles

It fills me with incredulity that anyone says a) bubbles are hard to spot and b) that anyone with knowledge of the field buys into the idea. How to deal with bubbles is always going to be trickier than calling them though, no-one wants to be the one responsible for removing the punch-bowl, particularly when there's no consensus on how much more punch everyone can consume before it turns messy.

GY - I worked for a short while for this organisation in DC, www.cepr.net/ a few years ago, they have some interesting papers but, on the whole, I'm not sure I'd trust some of their analysis. Dean Baker's work is certainly worth looking at even if you don't agree with all he writes.

[hobbes]

Central banks and asset bubbles

Can someone tell me why we don't do what the Dutch do and give tax relief on the mortgage of a first home and then tax additional homes/mortgages to buggery?

[Wyatt Earp]

Central banks and asset bubbles

I keep hearing this thread title to the tune of "Daytime Friends and Nighttime Lovers".

[Ginger Yellow]

Central banks and asset bubbles

Ibn - I'm a big fan of Baker. I actually agree with him more often than not, which doesn't usually happen with economists.

[Ginger Yellow]

Central banks and asset bubbles

Still can't find that chart, but that may be because I it was existing homes rather than new ones. I've been trawling through Brad's archives for existing home data as well, but I can't find the historical chart. This rather ugly chart was presumably derived from the same dataset, however, and makes the point:


"Real" is the National Association of Realtor's index of median existing home sale prices, while Shiller is the existing home index devised by Robert Shiller. See his March 2006 analsyis of the data here.

[Ibn Pickthall]

Central banks and asset bubbles

Baker gets quite a lot of attention but often for the wrong reasons, mainly other (often neo-lib) economists disagreeing with his left-wing stance rather than the points he makes. I did read something interesting on Mankiw's blog a while ago regarding an exchange they'd had, it was quite informative even if I didn't understand all the technicalities.
Both Baker and CEPR co-director Weisbrot are amusing characters, the latter definitely so, if you ever have the opportunity to meet/speak to them then most certainly take it.

[Ginger Yellow]

Central banks and asset bubbles

Mankiw's a weird one. Economists I respect have a lot of respect for him in general, but he spouted so much arrant nonsense while working for Bush that it's devalued pretty much everything he says.

[Ibn Pickthall]

Central banks and asset bubbles

An economist's economist, perhaps?
I gave up reading his work when I found out he'd called one of his cats "Keynes". Or maybe that was Romer, maybe I'm simply averse to macroeconomists.

PM for you anyway, GY.