Inside Investment: Asset bubble trouble
If central banks want to become macro prudential regulators, identifying asset price bubbles is necessary but not sufficient.
At first blush grey-suited central bankers do not have much in common with preschool children. However, anyone who has seen a toddler chasing soap bubbles only for them to elude their grasp might make a connection. In a paper presented at the central bankers’ jamboree at Jackson Hole, Wyoming, late last month, Charles Bean, deputy governor of the Bank of England, supported the idea that central banks could play a "macro prudential" role by deflating asset price bubbles before they wreaked lasting economic damage.
Bean chose his audience carefully. Alan Greenspan’s 19-year tenure as the chairman of the US Federal Reserve ended in 2006 but he still exerts considerable influence. In November 1998 the New York Times quoted him saying: "There is a fundamental problem with market intervention to prick a bubble. It presumes that you know more than the market."
Critics of Greenspan, such as Boston money manager Jeremy Grantham, regard this belief in the inviolability of markets as blinkered ideological tosh. It is a view that has served Grantham’s clients at GMO well. Grantham holds that when the price of any asset rises to two standard deviations above its long-run average (a one-in-40-year phenomenon), mean reversion is inevitable. In Grantham’s view the anatomy of bubbles is easily understood.
Madness of crowds
However, recognizing a bubble is only part of the problem. Policymakers must also decide when and how to act. Does the madness of crowds matter to the broader economy? This more subtle question requires a disentangling of the complex relationships between central banks, investor behaviour, asset prices, the supply of credit and the functioning of the financial system.
The linkages in the current crisis are all too apparent. Interest rates, particularly in the US, were kept too low for too long. This led to booming house prices, a bull market for stocks and a surge in credit aided and abetted by securitization. When credit markets seized up in August 2007 and originate-to-distribute turned out to be a myth, the edifice came crumbling down. Massive infusions of taxpayers’ money saved the day but credit conditions remain tight.
This is in marked contrast to the aftermath of the TMT boom and bust. Banks suffered a few bad quarters, trillions of dollars of investors’ money were wiped out but only the US fell into recession. Companies restructured or shuttered, investors licked their wounds but the global economy continued to grow. Leaning against the bubble with higher interest rates might have caused more harm than good. Tight money would have penalized businesses that were watching the TMT frenzy from the sidelines.
Back to Victorian economics
The booms and busts of the mid-19th century have more in common with the current crisis. In the early 1840s the UK economy was mired in a deflationary recession. The economy then expanded rapidly and this was accompanied by an investing mania for railway stocks. The balance of trade turned negative in 1847 and the Bank of England responded to the drain on gold reserves by raising its discount rate. Boom turned to bust and this precipitated a banking crisis.
Although the causes were different, similar crises unfolded in 1857 and 1866. In May 1866 a rise in the bank rate triggered the collapse of Overend Gurney and an ensuing financial panic. This marked a watershed. Until the Northern Rock debacle in 2007 it was the last time a bank failed in the UK. The Bank of England, partly at the urging of Walter Bagehot, learnt to act as a lender of last resort. Banking crises in the US in 1893, 1900 and 1907, were not replayed in the UK.
The UK even survived the Great Depression of the 1930s without a widespread banking crisis. The Bank of England was the first central bank to realize that the root cause of the problem was tight money, and quit the gold standard. Central banks around the world learnt from this and policy, regulation and supervision have grown ever more sophisticated. Until 2007 it was smugly assumed that banking crises were a problem confined to emerging markets.
The current vogue for macro prudential regulation is one result of this misplaced optimism. The recent financial crisis saw an extraordinary confluence of circumstances that ultimately overwhelmed the policy arsenal and knowledge that central banks had accumulated. It might be the case that as we all save more the wealth effects from falling stock markets do adversely affect the broad economy far more directly than was the case 20 or 30 years ago. However, the TMT boom and bust also suggests that policymakers should tread carefully before leaning against bubbles.
Interest rates, as Bean noted in his speech, are a particularly blunt tool. Investment manias that end in banking crises are not just precipitated by cheap money. They are also characterized by long periods of economic stability, rapid credit growth, financial innovation and investor over-confidence. Excessive leverage and one-way bets, such as the ubiquity of carry trades in the run-up to credit crunch, are common. Macro prudential regulators would do well to bear this in mind before setting off in pursuit of those damned elusive bubbles.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own