Wednesday, February 10, 2010

I seem, in Greenspan’s words, to have found a flaw in my previous beliefs

I cannot be certain about it right now, but well, let me show you via posts by two prolific economic bloggers.

1. Do low rates in and of itself cause a bubble?

I have been of the belief that loose central bank policy has been responsible for stimulating the bubble investor mentality of the last decade. Low interest rates cause people to speculate, therefore, the central bank should avoid doing so in the future. But here is a post from Nick Rowe, in which he describes his thoughts on bubbles, that introduces some doubts on my certainty about central bank complicity:

And, for what it's worth, I believe in bubbles because I believe humans tend to follow faddish beliefs in lots of things, and I don't see why their beliefs in asset values should be any different….The expectations about the fundamental component are expectations about something that has an objective existence apart from beliefs about it. The expectations about the bubble component are expectations about expectations. Like Tinkerbell the fairy, they only exist if we believe in them; otherwise they die. That's what should make bubbles unstable. If others stop believing in them, there is no reason for us to believe in them.

See the implication? When humans want to believe something, they can make it so. If they believe that something will go up in value, then it will go up in value, low rates or not.

Real bubbles are unstable; they burst when you prick them. They don't spontaneously revert to their original size…..How do you know if something was a bubble? If you prick it and it bursts, it probably was a bubble. If you prick it and it goes back to the original size, it probably wasn't.

See the implication here? Once an asset bubble has been burst, confidence in the asset should not easily come back. Nick here is talking about the Canadian real estate.

Now some might argue that the Bank of Canada's low interest rates have re-inflated the bubble. But if the metaphor "bubble" means anything, it means you can't just re-inflate it after it's burst. It's supposed to be unstable."

This can be taken to absolve the Bank of Canada, Fed, in causing bubbles. Implication here is that their policy actions cannot create a ‘bubble’ because it is primarily caused by people who believe in an asset’s continued price appreciation. If an asset has shown that its price can suddenly burst, why would anyone go back in that asset market? What kind of mechanical investor goes and piles back in an asset that has been already proven to be ‘burstable’?

Maybe you could argue that there was a bubble in Canadian house prices; that bubble has now popped; but the fall in long term interest rates has raised the fundamental value by enough to compensate for the popped bubble; so the net effect on prices is about zero. But higher unemployment, and lower expected growth in real incomes, should have reduced the fundamental value of houses, and may well have offset any effect from lower interest rates.

Implication here is that lowered rates are a central bank’s policy to offset lower incomes, and an offset to owners for the lowered nominal prices. There is inevitability to the lowered rates, because short of the government handing out money to offset everyone’s lowered income, lowered rates seemed to be the only way to get everyone on the same cost level they were in before. No central bank blowing bubbles? Now if the lower rates also happened to raise asset values by enough to compensate for the popped bubble, does this mean it was stoking a bubble in the first place?

Here’s Nick’s reply: Since we don't really have much in the way of a theory about when bubble start and stop, it is hard to say whether monetary policy (or, more strictly, the need for interest rates to be low) was or was not responsible. There is some possibility that low interest rates make bubbles more likely to form, because very small changes in fundamentals (like expected growth rates) will then have bigger effects on fundamental values, so it becomes harder to tell what the fundamental value of an asset is. And *falling* (as opposed to low) interest rates, by causing rising fundamental values and prices, may sow the seeds of a bubble. But this is so speculative.

If low interest rates cannot be convincingly linked to the rise in asset prices, perhaps quantitative easing could be making the difference. Well, first off, here’ s Scott Fullwiller in reply to my query: Banks don't lend reserves. They create a loan, which simultaneously creates a deposit. Quantitative easing does absolutely nothing for banks' operational abilities to create loans. Banks are capital constrained, not reserve or deposit constrained.

And in a post by him…. the bank clearly does not have to be holding prior reserve balances before it creates a loan. In fact, the bank's ability to create a new loan and along with it a new deposit has NOTHING to do with how many or how few reserve balances it is holding. In other words, there is no loan officer at any bank that checks with the bank's liquidity officer to see if the bank has reserves before it makes a loan.

What constrains a bank in the creation of new loans and deposits, then? First, there is the fact that there must be a willing borrower . . . one whom the bank deems to be creditworthy. Second, the loan must be perceived as profitable . . . in this case, the bank's ability to raise deposits does matter, since it probably expects the borrower to withdraw the deposit it will create, and finding new deposits is much cheaper for the bank than borrowing from other banks or from the Fed. Third, the loan must be on the regulator's approved list of assets, and if the loan results in an expansion of the bank's balance sheet, the bank must be aware of the impact on its capital requirements and other financial ratios with which the regulator is concerned.

Okay, in short, the central bank in adding reserves does not necessarily lead to more lending. Now I’ve been of the view that since QE changes the yield curve on treasury debt, transferring income from savers to borrowers, then QE can increase the supply of money in circulation, or at the very least, the amounts banks could be willing to lend. This is the only way to reverse the trend of transferring income from savers to borrowers.

But it can’t be denied that no additional lending is encouraged if no profitable accounts can be found. The banks have to therefore ‘believe’ that there are creditworthy and profitable accounts before they will undertake in more lending.

2. How much of the bubble is really controllable by the central bank?

Now neither can banks use excess reserves to speculate directly, as the regulatory capital cost of using them is more expensive than the reserve itself. But there is arguably a ‘bubble’ in a lot of asset classes: treasury bonds, emerging market debt, commodities. There must then be some other source of funds for the speculators who are, as Roubini terms it, doing the mother of all carry trades. If the commercial banks haven’t been funding the recent speculation in a big way, then these other sources, in and of themselves, can cause the bubble. They could be the mutual and money market funds, hedge funds, etc. Now none of these are within the central bank’s purview, but they all have scores of liquidity that are no longer funnelling towards the commercial banks, and they respond to low rates by reaching for yield in riskier asset classes.

So I have two questions:
If central banks cannot cause bubbles, they cannot also do anything to burst them. If rate setting and quantitative easing do not affect the market , once they already have their own beliefs about assets and potential accounts, then what is the central bank’s economic use, beyond regulation, that cannot be done by Treasury? (Though I think we're seeing a lot of indications that it really needs to be a stronger regulator, if we want borrrowers to be protected.)

And if the case is indeed that low rates can and does influence the creation of bubbles, and the effect is transmitted in the market via financial entities that are beyond central bank purview, should it then be regulating everybody else?

update: no more doubts about Fed ability to create bubbles


AndyfromTucson said...

To me there is one simple proof that low interest rates do not cause bubbles. If low interest rates alone caused bubbles, then all assets would bubble simultaneously when rates are 'too low.' Since only some assets bubble when rates are low it is obvious (to me) that at best low rates are a necessary, but not sufficient, condition for a bubble.

But just because low rates do not cause bubbles doesn't mean that high rates can't pop bubbles. Low rates will not get people to borrow and spend on investment/speculation if all the investment/speculation opportunities out there look dismal. However, high rates can make any and all investment/speculation opportunities unprofitable, and raising rates high enough will eventually kill any bubble (and take down the rest of the economy with it).

The way I think about it is that low interest rates are like water for farming. Having lots of water doesn't necessarily mean you will get a good crop, but having no water is certain make everything die.

Assuming central banks still have the power to set retail market interest rates then central bank rate setting could have a dramatic role in popping bubbles and curbing inflationary surges through setting high rates. However, as we have seen, low rates have a limited ability to promote growth when the general economic climate is grim.

Anonymous said...

What AfT said^^.

Rogue Economist said...

Thanks for chiming in, Andy. I agree that low rates are a necessary, but not sufficient, condition for a bubble. But my thinking right now is that not all assets need to simultaneously bubble, because people's beliefs can make a distinction of which asset to pile into. Usually it's an asset with a 'perceived' scarcity. But yes, I'm beginning to think that the low rate itself can't be faulted for the bubble, because if anything, it is a symptom of a grim economic climate.

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