asset bubbles

Simone Baribeau

Gotta hand it to the Financial Crisis Inquiry Commission – They’ve got their work cut out for them tomorrow, if they want to get any new information at of former Federal Reserve Chairman Alan Greenspan.

Mr Greenspan has written his memoirs, published a 66-page paper on the crisis, and been interviewed by Congress and the media ad naseum.

So what questions could the FCIC possibly ask that would shed more light on Mr Greenspan and his views? We’ve asked the Fed watchers. Here are their responses. 

Simone Baribeau

Fed leaders – past and present – have chosen today to be awfully talkative. And they haven’t at all times been in agreement with each other, either. So here are the highlights of today’s Fed speak.

Alan Greenspan, Former Fed chief, on the Bubble

Alan Greenspan, in an interview with Bloomberg TV, disagreed with SF Fed president Janet Yellen’s assessment that an increase in interest rates could have mitigated the growth of the housing bubble. He argued, as he has before, that a decrease in long term interest rates around the world led to the boom. Short-term interest rates were irrelevant.

Ok – so long-term interest rates are responsible for the bubble. We sure don’t want to encourage a housing bubble based on that again. Right?

Maybe not. 

Simone Baribeau

President Barack Obama is reported to be looking at San Francisco Fed president Janet Yellen to fill Donald Kohn’s vice chairman seat when he leaves this summer. So what had Ms Yellen been looking at to boost the US economy?

Housing, she said in a speech today.

Ms Yellen, San Francisco Fed president, said last year she “became hopeful that the sector would provide a significant boost to the economy this year.”

But then, she said, the market seemed to have stalled. Indeed, home sales data released earlier today and the impending end of the home buyer tax credit bode poorly for a home price bottom.

Optimism on housing is nothing new for Ms Yellen (or, as we know, other FOMC members). 

James Politi

What’s in a dissent? Quite a lot, potentially. Thomas Hoenig, the notoriously hawkish president of the Kansas City Federal Reserve Bank, had already disagreed at the last FOMC meeting on the reference to an “extended period” of low interest rates – saying the economy was strong enough that higher rates could be contemplated at some point sooner. Mr Hoenig disagreed again with his colleagues today, but elaborated on his reasons for doing so. It was not for fear that low rates could lead to a spike in inflation, as one might think, but rather because of concerns over a potential new asset price bubbles. “It could lead to the buildup of financial imbalances and increase the risks to longer run macroeconomic and financial stability,” the Fed said in the last line of its statement, explaining Mr Hoenig’s position.

This could open up a whole can of worms. Although certain asset price bubbles can be inflationary for the economy as a whole, there may be a debate about whether considering financial stability on its own when crafting monetary policy is consistent with the Fed’s dual mandate under law, which is to maximize employment while maintaining stable prices. Purists might argue it is not, others might argue that it is.

Simone Baribeau

Mark Carney, Governor of the Bank of Canada, today spoke on Canada’s response to the financial crisis. In a question and answer period after the speech, Mr Carney said (via Reuters):

Our view is that the first line of defense of financial stability is regulation and we would underscore the experience with Canada, Australia, other major inflation targeters has been that you can have your cake and eat it too — you can have price stability, you can have financial stability if you get the regulatory side right.

As the governor of the central bank in the only country in the G7 that avoided bailing out its banks, Mr Carney has good reason to tout his country’s success. But what if the crisis has yet to pass? 

Simone Baribeau

The IMF said that it did not take proper account of asset price booms when assessing Ireland’s fiscal situation in a paper today.

The paper said that the IMF’s calculation of the structural fiscal balance of Ireland was broadly based on the OECD approach. “While this approach works well in many cases, recent events have highlighted its limitations under certain circumstances, such as property or other asset price booms.” 

Simone Baribeau

Who’s afraid of global growth?

Jürgen Stark, member of the executive board of the ECB, for one. At least, if it’s the wrong kind of growth.

One striking feature of the high global growth rates was the reliance on large and unsustainable global imbalances. In principle, current account imbalances can be desirable, if they channel funds across the world to their most productive use. But in the years prior to the crisis imbalances were a symptom of economic distortions: in some countries asset price bubbles developed and household debt levels rose beyond sustainable levels. Eventually, the rise in the household debt burden resulted in an acceleration of defaults on mortgage and consumer loans, which undermined the stability of the financial system.

In other countries for example, in emerging Asia which held the value of their currencies at artificially low levels to support their export-oriented growth strategies, the vast accumulation of foreign exchange reserves had potentially high opportunity costs. These managed exchange rate regimes may also have contributed to hampering necessary domestic adjustments and distorting the allocation of resources towards export-oriented industries.

His solution (in part): 

Simone Baribeau

One way to assess if housing prices are rising for real reasons (ie, the property is becoming more valuable) or if they’re part of a bubble (ie, it’s a speculative boom, bound to crash) is to compare housing prices in a given area with rental prices. If housing prices are rising much faster over a prolonged period of time than rents, you’ve probably got a bubble on your hands.

Which begs the question: how do you measure rents? 

Simone Baribeau

Eric S. Rosengren, president of the Federal Reserve Bank of Boston, today gave a speech on asset bubbles and systemic risk. It’s more or less in line with Bernanke’s line: monetary policy wasn’t the main culprit in inflating the housing bubble and so the problem requires a regulatory fix.

Mr Rosengren calls for forward-looking, systemic risk supervision, which he says is a “serious gap” in financial regulation.

The systemic supervision that is needed would focus on possible future losses and is inherently forward-looking. Doing this well requires an understanding not only of institutions but also markets, and it requires taking into account the full range of outcomes, both expected and potential – including those that have a low likelihood of occurring but that could have serious adverse consequences. While we may not be able to eliminate all bubbles, we should be able to limit the degree to which the financial sector feeds and propagates these booms, and the sector’s vulnerability to subsequent busts.

Mr Rosengren doesn’t spell out exactly what tools the regulators would have at their disposal if they identified a risk of an asset bubble. But, where a bubble exists, 

Simone Baribeau

Jeffrey M. Lacker, president of the Federal Reserve Bank of Richmond, today argued that the primary reason for financial market instability was a poorly defined government safety net for financial institutions. The bursting housing bubble, he said, caused pain for financial groups, but there was nothing fundamentally destabilising about it: institutions overvalued certain assets, and as the market corrected itself, people lost money.

The considerable downturn in housing market fundamentals alone would have led one to expect substantial movements in financial prices and quantities, with attendant strains for many institutions, even in a very well-functioning financial system.

Interconnectedness isn’t inherently destabilising, he argues. Financial institutions have every reason to “neglect the implied exposure to their counterparties’ counterparties.”

But, he says, the moral hazard created by the government’s implied guarantees to large interconnected institutions is destabilising.