How should monetary policy respond to asset price bubbles?

Stephen Cecchetti 01 December 2004

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Central bankers strive to deliver stability in prices, growth and the financial system. Asset price bubbles present a direct threat to achieving these goals, so monetary policymakers have no choice but to accord them a role in their policy decisions. When equity and property prices take unjustified trips into the stratosphere, they cannot be ignored. Unless alternative policy instruments can be developed, today’s monetary policymakers have no option but to raise interest rates when faced with an emerging asset price bubble. 

This activist conclusion is based on careful consideration of the damage asset price bubbles do to companies’ investment decisions, households’ investment and saving decisions, and the government’s fiscal policy decisions. We can look at each of these in turn. For firms, unjustifiably high equity prices make it too easy to obtain financing. What happens is simple. The feeding frenzy of a bubble allows people to sell shares for prices that are impossible to justify. It is not much of a challenge to find examples of internet companies that were able to raise staggering sums of money in equity markets in the 1990s, only to crash and burn several years later. The funds they used could clearly have been better invested elsewhere. Not only that, but this episode has now made it extremely difficult – arguably too difficult – for high-tech startup companies to obtain any financing at all. Following a bubble, the structure of the economy can take years to recover. 

The impact of equity and property price bubbles on consumer behaviour is equally damaging. Rising share and house prices make individuals feel wealthier. And the richer people are, the more of their income they spend and the less they save. When the bubble eventually bursts, wealth is recomputed and consumers are left with houses and mortgages that are too large for their paychecks, and investment accounts that are shadows of what they once were.

Asset price bubbles distort government financing decisions as well. As equity prices rise, tax revenues tied to capital gains go up. Increased government revenue leads to increases in expenditure and cuts in taxes. With the bursting of the bubble, tax revenues have fallen dramatically. In the current political environment, it is impossible to raise taxes, and so the result is a combination of expenditure cuts and increased borrowing. At least a part of the current American fiscal imbalance is a consequence of the internet bubble of the late 1990s.

In thinking about the impact of bubbles, it is important to distinguish equity from property prices. While they affect the economy through similar channels, the magnitudes tend to be different. Booms and busts in equity prices are much less damaging to an economy than soaring property prices. There are two reasons for this. First, individual consumption decisions are much more sensitive to changes in housing prices than to fluctuations in equity prices. Second, in countries where housing purchases are financed by borrowing (as in the US, the UK, and a number of other countries), bank balance sheets are exposed to the impact of the crash.

All of these theories are backed by historical evidence. Several years ago, in the April 2003 World Economic Outlook, the IMF reported that the average equity price bust lasts for 2½ years and is associated with a 4% GDP loss that affects both consumption and investment. While less frequent, housing price busts last nearly twice as long and have been associated with output losses that are twice as large because of what happens to banks.

Central bankers know all this. They are aware of the pathology of asset price bubbles, and the costs they extract when they burst. Nevertheless, monetary policymakers’ natural conservatism makes them hesitant to use interest rate policy to combat the resulting instability.

Critics of the activist approach to bubbles marshal various arguments to justify inaction. The most powerful is that responding to bubbles means estimating the extent to which asset prices deviate from fundamentals. How can anyone think that policymakers know better than the market what level of share and housing prices are warranted by long-term conditions? Just because asset price misalignments are difficult to measure is no reason to ignore them. The normal response to noisy data is to use statistics to try to improve its quality, and barring that to respond with caution, taking the uncertainties into explicit account. If central bankers threw out all data that was poorly measured, there would be very little information left on which to base their decisions.

While there will always be debate over whether equity price bubbles are even possible, the same cannot be said for property prices. Unless the financial system radically changes, it will remain both impractical and expensive to sell a house short – that is borrowing someone’s home, selling it into the market with the intention of buying it back on a future date in order to benefit from a price decline. The absence of this mechanism raises the likelihood that housing price bubbles can develop. Ready examples include the experiences in Japan in the late 1980s, the UK in the past few years, and the US today.

Today, the only viable response to these asset price bubbles is to tighten monetary policy. A reasonable reaction to this conclusion would be to ask whether there aren’t any alternatives. Why not look for another instrument that can be targeted directly at the problem?

Knowing the limitations of current monetary policy arrangements, economists inside and outside of central banks have been working on developing alternative instruments. To see what might be both desirable and practical, we can start by noting that leverage is the ultimate source of the instability caused by bubbles. That is, the boom-bust cycles arise because people borrow to make purchases at high prices. And the financial system is put at risk because of the loans that are backed by collateral valued at inflated prices. The natural response is to look for policies capable of tempering the level of borrowing.

For equity bubbles, economists have suggested adjusting margin requirements. Margin trading accounts for approximately 20% of total trading in US equity markets. Increasing the cost of these transactions during periods when prices have been rising quickly has the potential to keep bubbles from growing large.

For property price bubbles, reducing leverage means changing the terms of mortgage lending. It would be straightforward to increase buyer net worth requirements, imposing borrowing limits that decline depending on the speed with which prices have recently increased. These limits could be imposed either directly, or through risk-based capital requirements on the lenders. Regardless, they would both reduce the liquidity buyers are using to fuel the price boom, and force financial institutions to reduce their exposure to a possible property price collapse.

These ideas have tremendous appeal. Authorities could turn to regulatory tools to address equity and property price increases that are not justified by underlying economic conditions, leaving interest rates to pursue more traditional policy goals. But until the efficacy of alternatives has been proven, central bankers are left with interest rates as their only tool. And the right response to emerging equity or property price bubbles is to raise interest rates. This is never popular, but if policymakers are to do their job of stabilising the economic and financial system, this is what they must do.

This article first appeared in the Financial Times, http://www.ft.com/home/uk

 

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Topics:  Monetary policy

Tags:  asset price bubbles, house prices, equity prices