Canada's Housing Bubble

For years, central banks have only cleaned up after asset bubbles burst. But now there's a growing movement afoot to change that.

Jun 21, 2010 David Pett Financial Post

Financial stability will be a key topic at the G8/G20 summits. In the third of four-part summit series, FP looks at how central banks may change to help achieve that goal.

In economic circles, it’s simply known as the “mop up” strategy.

It’s the idea that central banks should neither target asset bubbles, nor use their power to deflate them. Only when bubbles burst, should central banks then move in to clean up the mess using a swift injection of liquidity via lower interest rates. For years, the approach has been a cornerstone of monetary policy, one that seemed to successfully limit the fallout from a number of financial crises that have transpired over the past quarter of a century.

But in the aftermath of the worst global recession since the Great Depression — sparked by the bursting of the U.S. housing bubble — the orthodoxy surrounding this central tenet is now being questioned.

Indeed with financial stability front and centre of the G8 and G20 meetings this weekend, the Bank of England has taken the lead on a more activist approach to managing asset bubbles that many analysts now advocate.

Last week it announced it would create a Prudential Regulation Authority to supervise the U.K.’s financial firms as well as a Financial Policy Committee to monitor threats to the economy from financial developments such as asset bubbles. Both will be arms of the BOE.

“The lesson learned is that asset bubbles have massive implications, not just on Wall Street but on Main Street as well,” said Paul Taylor, the chief investment officer at BMO Harris Private Banking said. “We need to identify who should be responsible for them and what tools they have at their disposal to limit their impact.”

The standing orthodoxy around asset bubbles is synonymous with Alan Greenspan’s tenure as chairman of the U.S. Federal Reserve between 1987 to 2006.

In 2002, just two years after the dot-com bubble exploded and sent equity markets down 40%, Mr. Greenspan argued that central banks have no chance to prevent bubbles, first because they are near impossible to recognize and second because the central bank’s main policy tool, the short-term interest rate, is too blunt an instrument to slow asset prices and not risk serious harm to overall economic growth.

“Nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble,” he said during a speech. “The notion that a well-timed incremental tightening [can be] calibrated to prevent [a] bubble is almost surely an illusion.”

While Mr. Greenspan’s argument raised some eyebrows at the time, it went largely uncontested for years. Most central bankers and professional economists widely agreed that a central banks’ primary, if not exclusive, role was to target stable and low inflation. That meant ensuring price stability for an index of consumer goods, which by definition excluded prices of assets like real estate and equities. Yes, the increased value of one’s home or stock portfolio could have an influence on consumer prices by making investors richer and thus encouraging more consumption, but beyond that, asset prices should not play a role in monetary policy.

Evidence in the real economy seemed to support this view as well. The focus on stable prices and low inflation since the early ‘80s had coincided with a period of high economic stability or the Great Moderation as it has been coined. In addition, the policy response to shocks such as the 1987 stock market crash, Long-Term Capital Management collapse and tech wreck, was largely successful.

“By the mid-2000s, it was indeed not unreasonable to think that better macroeconomic policy could deliver...,” Olivier Blanchard, chief economist at the International Monetary Fund said in a note earlier this year. “Then the crisis came.”

A main criticism of central bank policy that has intensified in the almost two years since Lehman Brothers went bankrupt is the role it played in creating moral hazard. By doing nothing in the period that bubbles are building up and pre-announcing its role as saviour once they burst, central bankers give markets a false sense of insurance, but also may be sowing the seeds for even bigger crisis in the future.

“Clearly, the we-can-clean-it-up-cheaply-after the bubble-bursts-with-low-interest rates argument can be discarded (at least for cases where the buildup of the bubble involves significant leverage),” said Morris Goldstein, an economist at the Peterson Institute of International Economics, a U.S.-based think tank.

He said the argument that bubbles can not be identified in advance is also being challenged by promising research done at the Bank of International Settlements as well as the IMF.

“If it remains difficult to identify bubbles before they get too large, the message now to both central banks and regulatory authorities is: ‘I know, but try much harder,” he said in a note.

The BOE’s two new monitoring authorities are specifically designed to identify asset bubbles and extreme leverage and if need be tame them using instruments such as capital ratios, margins on equities and loan-to-value ratios on residential and commercial mortgages.

Mr. Goldstein said such macroprudential actions run the risk of killing off some expansions too soon, but also hold the promise of avoiding another severe collapse. “I think it’s well worth a try,” he wrote.

Mr. Blanchard at the IMF says using additional tools other than the policy rate to target excess leverage and risk taking also leaves central banks free to use interest rates for what they were intended: namely consumer price stability. Ultimately, the central bank should be in charge of both monetary and regulatory athorities, according to Mr. Blanchard.

Mervyn King, governor of the Bank of England, echoed these sentiments last week, saying, “monetary stability and financial stability are two sides of the same coin.”

But not everyone is happy about giving such power to central banks. Many people feel that central banks would take a softer stance on inflation because interest rate hikes could be negative to bank balance sheets. Others are worried a more complex mandate will water down accountability.

“I think it should be another regulatory agency,” said Pierre Lapointe, a macro global strategist at Brockhouse Cooper. “The role of central banks shouldn’t be to avoid bubbles but to control inflation. That’s their task.”

Instead of regulating asset prices, he said it is more important to limit financial leverage, which multiplies the negative impact when bubbles burst.

In Canada, banks were less affected by the financial crisis in large part because they were better regulated with regard to both capital levels and leverage but also highly opaque financial instruments. Mr. Lapointe said this regulation was not the domain of the Bank of Canada but another government agency, the Office of the Superintendent of the Financial Institutions.

Regardless of how governments choose to tackle new regulations, the challenge for policy makers around the world will be coordinating a regulatory climate that will ensure some level of financial stability and prevent another financial catastrophe.

“Capitalizing on the experience of the crisis, our job will be not only to come up with creative policy innovations, but also make the case with public at large for the difficult but necessary adjustment and reforms that stem from those lessons,” Mr. Blanchard said.