Pricking bubbles in the wind: Could central banks have done more to head off the financial crisis?

It is necessary to reintegrate financial market analysis, credit and asset prices into the monetary policy regime

(pages 3-7 of printed journal)

By Howard Davies


DaviesThe world economy is beginning to recover

There are persuasive signs that the world economy is beginning to recover, and Australia may avoid a technical recession altogether. But we should not forget that the costs of the credit crisis are huge in terms of lost output, lost jobs, and fiscal deficits. In the UK, the crisis is the fourth largest fiscal event in history, after the Napoleonic War and the two World Wars of the twentieth century. In the US, the government's commitments - which may not all be called - are twice as large as the cost of World War II.

So it is important to ask why the crisis arose in the virulent form it did. Many culprits have been identified: sleepy regulators, greedy bankers, poor risk managers, negligent (or worse) rating agencies. The political right tends now to argue that too much regulation was to blame; the left, that the problem was too little. But almost everyone agrees that an overhaul of global regulation is in order.

The role played by central banks

Should we not also, however, look at the role played by central banks as monetary authorities?

As Charlie Bean, Deputy Governor of the Bank of England, noted, 'You need fuel to make a fire, too. And that was provided by the ex ante excess supply of global savings over investment, which pushed real interest rates on safe assets to historically low levels, reinforced by loose monetary policy.'

Others put forward a stronger critique, and maintain firmly that the crisis was 'made in the Fed'. Steve Roach, the former chief economist of Morgan Stanley, does not mince his words. 'Central banks', he argues, 'were asleep at the switch. Central banks have failed to provide a stable underpinning to world financial markets and to an increasingly asset-dependent global economy. It is high time for monetary authorities to adopt new procedures - namely taking asset markets into explicit consideration when framing policy options.'

John Taylor points out that interest rates in the US were, from the end of 2001, held significantly below the level which his rule would have indicated. He argues that this deliberately loose monetary policy was the direct cause of the house price boom and subsequent bust.

At the time, most central bank governors did not accept the argument that asset prices were giving dangerous signals, though Bill White, then chief economist at the BIS, argued for a greater focus on credit expansion and asset prices, and did so well before the crisis hit. Surely, he argued, there was a point at which it was possible to identify asset mispricing and bubbles? Why could interest rate policy not take some account of the risks posed by escalating asset prices, just as it did with other risks to inflation and growth? BIS economists became closely identified with the proposal that the monetary authorities, even those with a tight inflation objective focused on retail prices, should have been prepared to 'lean against the wind' of asset price escalation.

The central bank response to this heterodoxy, both before and during the crisis, was robust. Alan Greenspan challenged every link in the chain of argument. In his view it was not possible to identify when a bubble was inflating, and even if it were possible so to do, a monetary response would be ineffective. Furthermore, it would be undesirable to attempt to respond in a way which might constrain markets and hinder the processes of innovation. Instead, central banks should forget about preventive measures and 'focus on policies to mitigate the fall-out when it occurs.'

These contrasting points of view seem to admit little possibility of accommodation. Yet there are more recent signs that central banks, faced with the massive value destruction of the last two years, are becoming more pensive about their record. If the bust is so dramatic and costly, should we not consider whether we might not have done more to avert it?

It is therefore worth picking through the details of the dispute to see if the outline of a more effective approach might emerge - one which does not compromise the success achieved in anti-inflation policy, but gives greater weight to financial stability.

Five questions

To do so it is useful to parse the argument into a series of questions on which different points of view are advanced.

Q1 Should central banks target asset prices?


On this, there is a large measure of agreement. Even those who argue for 'leaning against the wind' do not think central banks should target asset prices directly. So the argument is not about adjusting the definition of inflation on an ad hoc basis as asset prices fluctuate. It is about how far decision-makers should take account of asset price misalignments in setting interest rates.

Q2 Should the measure of inflation targeted include an element of asset price, and particularly house price inflation?

The current definition of inflation used in the UK and in EMU excludes any element of housing costs. In the UK the target rate was changed from the RPI, which did include an element of imputed house rental costs, to the CPI, on the model of the Harmonised Index of Consumer Prices used in the Euro area, in 2003.

Since then, the Bank of England has changed tack, and the Governor has now accepted that it would be preferable to change to a measure which did incorporate an element of housing costs.

So there appears to be an emerging consensus on this point. But just how sizeable an element of housing costs should be incorporated in the target rate is likely to prove far more controversial. In the US, the index includes an estimate of the price of owner-occupation based on a survey of rental costs. Stephen Cecchetti has calculated the impact on US inflation were that element to be replaced by an index of home sales prices. The effect is dramatic. Over five years from 2000, recomputed inflation would have been three quarters of a per cent a year higher than on the CPI index used. In the UK, the effect would have been even greater.

So while some readjustment of the index might be helpful as a signalling mechanism, it is highly unlikely that the adjustment would be anything like as dramatic as Cecchetti's calculations imply.

The third question is where things get more difficult.

Q3 Is it possible to identify serious asset price misalignments, and are they of legitimate concern to monetary policy-makers?

Advocates of 'leaning against the wind' argue that there are long-run measures which can help to identify mispricing. In the equity markets, extravagant price-earnings ratios were a powerful leading indicator of trouble in the dot com boom. More recently, a dramatic fall in the risk premium on high yield bonds was a strong sign of mispricing there. In the case of housing there are price/earnings ratios, and perhaps more importantly price/rental income ratios, which point to the likelihood of downward shifts. The growth of credit aggregates may also be helpful in identifying unsustainable asset price increases. These indicators cannot be used as automatic triggers, and misalignments may persist for some time, but the uncertainties are no greater than in many other areas where the monetary authority has to take a view.

Q4 Even if we can identify misalignments, and believe that some price adjustment is bound to occur, is it right to use interest rates to try to moderate the expansion?

It is striking how often in this debate the opposing sides caricature each other's positions. So advocates of the use of the interest rate weapon prefer to use the non-threatening metaphor of 'leaning against the wind'. Those who resist it typically raise the stakes by talking of the risks of trying to 'prick bubbles'.

In Bernanke's view, the scale of interest rate changes needed to make a significant impact on a price bubble, whether in the equity or property markets, would be so large as to threaten the health of the economy overall, and inflict greater damage on economic welfare than a policy of benign neglect, followed by aggressive easing if necessary.

But there is evidence that 'leaning' can be useful.

The Swedish Riksbank believes that its actions did have a helpful effect on the expansion of asset prices in Sweden, though they did not avoid a fall in 2008. The ECB, too, maintains that it takes asset prices into account in the monetary pillar of its analysis.

So there is a clear fault-line here within the central banking fraternity. The experience of 2007-08 strengthened the hands of those who favour 'leaning against the wind', and the language used by Governors has begun to change. Yet the Greenspan tendency is not down and out. Two months ago, Mervyn King argued, 'Diverting monetary policy from its goal of price stability risks making the economy less stable and the financial system no more so.'

Both sides are agreed, though, that interest rates are not the only weapon that can be used. Even central banks - which paid little attention to bank regulation before the crisis - are showing more interest in capital requirements. That leads to the fifth and last question.

Q5 Should we try to find and use mechanisms other than interest rates to moderate extravagant credit expansion and associated asset price bubbles?


Almost all central bankers would now answer yes, in principle, to this question, whether or not they believe that interest rate changes should also be used to that end. They tend to point to the use of variable capital ratios in the banking system. But raising capital ratios as a precautionary move will also affect the economy as a whole, unless regulators use some kind of sectoral approach (raising capital in relation to mortgage finance only, for example - likely to be a politically unpopular move). Credit rationing will feed into price through interest rate changes, which will themselves affect the monetary stance. So a macro-prudential mechanism is not an easy option, and should be considered alongside the interest rate decision, not apart from it.


Conclusions about 'leaning against the wind'

In my view, central banks must pay more attention to asset price bubbles than they have in the recent past.

I am not persuaded by the argument that bubbles cannot be identified ex ante. Of course assessing price misalignments is not an exact science, but nor are many other aspects of monetary policy. Furthermore, I believe that asset prices should be identified as an explicit factor in the consideration of policy, and an element of housing costs should be re-incorporated in the index as soon as possible. That would help to explain policy.

I argue that, in future, monetary policy decision-makers in central banks should pay more attention to the creation of credit, both within and without the banks, in reaching decisions on interest rates.

I recognise that the interest-rate weapon is powerful and blunt. There will be circumstances in which it will be more appropriate to act directly on the expansionary appetites of banks themselves, through adjusting capital requirements. We have to recognise, though, that the application of additional capital requirements for macroeconomic reasons, not directly related to the risk positions of individual banks, will feedback to interest rates and hence monetary policy.

Adjusting capital requirements to the state of the economic cycle would be very difficult. The decision to impose higher capital requirements would require courage on the part of economists and supervisors. But if the assessments were agreed by central banks from a broad range of countries, they would have authority and give line supervisors the cover they need to impose unpopular 'taxes' on their banks. We need to recognise that, at bottom, a macro-prudential tool is a tax, and one whose cost would largely be passed through to borrowers and savers. Now would be the right time to introduce a system of this kind, when the memories of the crisis are fresh and the wounds still raw.

At the G20 summit in April, Heads of Government agreed in principle that macro-prudential measures should be agreed, though it is not wholly clear that they knew quite what they were asking for. There is much work to do before we have a workable system, but it should not blind us to the need to reintegrate financial market analysis, credit and asset prices into the monetary policy regime. If it is conceived as a substitute, then it will inevitably disappoint.

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A condensed version of the 2009 David Finch Lecture delivered on 13 August at the University of Melbourne. The Lecture was established through the generosity of C David Finch, a distinguished alumnus of the University. The full paper is published in the Australian Economic Review 42, 4, December 2009.

Sir Howard Davies, is Director of the London School of Economics, a post he took up in September 2003. Other important positions he has held include Chairman of the Financial Services Authority; Deputy Governor of the Bank of England; Director-General of the Confederation of British Industry; Controller of the Audit Commission; director of GKN plc; member of the International Advisory Board of Natwest; Foreign and Commonwealth Office and H M Treasury, both as an official and as special adviser to the Chancellor of the Exchequer; and management consultant for McKinsey and Co. Inc.

He writes regularly for the Financial Times and his reviews include fiction for the Literary Review and The Times, and historical and economics books for the Economist, The Times, the TLS and the Times Higher.

He is a Trustee of the Tate, a member of the governing body of the Royal Academy of Music; Patron of Working Families; and in 2004 was elected to an Honorary Fellowship at Merton College. Since 2003 he has been a member of the International Advisory Council of the China Banking Regulatory Commission. In 2004 he joined the board of Morgan Stanley as a non-executive director, and in 2006 joined the Board of Paternoster Limited, a new insurance company. In 2009 he became an advisor to the Government Investment Corporation of Singapore.


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