Monday, January 25, 2010

Modelling asset bubbles caused by low interest rates

I have blogged extensively about the classic dilemma facing central bankers as they face an inflating bubble - whether to ex-ante take away the punch-bowl as the party gets going or post-facto clea n up after the bubble bursts. The challenge as Joseph Gagnon writes is "how to walk the fine line between easing too little to fight unemployment and easing too much to cause a new and harmful bubble".

Brad DeLong explained the situation with a simple model of a bubble caused by a central bank holding interest rates below its long-run equilibrium so as to boost aggregate demand and thereby fight an economic slowdown. He describes such bubbles as being caused by a "carry trade" (income earned over their cost of borrowing) arising from speculators borrowing at the low short-term interest rate to purchase a long-term asset at a price above its long-run expected value. Despite being aware of the risk of an asset price crash when the central banks reverses its loose money policy, they are confident of timing their exit with their profits before the prices of the long term assets starts declining. The moral hazard arising from the now near certainty of a bailout only adds to their confidence and adventurism about taking deep speculative positions. He writes,

"The more speculators ex ante expect bailouts and the more speculators are impressed with their own cleverness, the more hesitant should the central bank be about providing monetary accommodation. William McChesney Martin said that the job of the Federal Reserve was to take away the punchbowl before the party got rolling. Alan Greenspan thought that as long as there was an Okun gap and no sign of inflation the Federal Reserve should spike the punchbowl with the grain alcohol of low interest rates because it could, if necessary, serve as designated driver to get everybody home safely. In this finger exercise it is William McChesney Martin who is right. And how right he is depends on the vulnerability of the market—on speculators’ expectations of rescue (the 'Greenspan put') and on speculators’ confidence in their own expertise."

Joe Gagnon feels that the De Long model overstates the welfare costs of bursting bubbles by assuming that "all declines in long-term asset prices are costly even if they are not associated with bubble-like behavior" and by ignoring "the role of unleveraged or partially leveraged investors". He feels that in the process the model places an excessive importance on the role of monetary policy without consideration for other critically important factors like leverage. He therefore differs with De Long's assumption that apart from the cost of any bailouts, the welfare cost of a bursting bubble is an "amount proportional to the squared losses of the investors" and points attention to the important role played by leverage. He writes,

"This welfare cost, however, implicitly assumes that investors are fully leveraged and thus are forced to default on their short-term loans whenever long-term asset prices fall, even when there is no bubble. This feature of the model is clearly unrealistic... In a world of unleveraged (or lightly leveraged) investors, falling asset prices would not bankrupt anyone and thus would not raise fears of bankruptcy. In such a world, there are no welfare costs of a bursting bubble, at least as long as the central bank acts nimbly to keep the economy on track. It is true that investors suffer a decline in wealth, but only from a level that was not fundamentally correct to begin with."

Coming to the present, given the strong and bitter memory of the events of recent past, he feels that strong leverage driven increases in asset prices are not likely now. He therefore argues in favor of monetary policy actions to support and even increase the prices of long-term assets now to speed economic recovery and avoid deflation. He also feels that the possibility of a sustained low interest rate driven bubble in commodities is remote due to problems in storability, and points to the sharp rise and decline of oil prices in 2008 as an example of this.

However, there is increasing evidence to the contrary that such optimism about any salutary effects of the Great Recession (on investors and bankers) may be misplaced and that the age of leverage may be far from over.

About the fundamental lesson from the recent crisis, he writes,

"The global financial crisis demonstrates the need for reforms to greatly reduce the leverage of financial institutions and to make that leverage respond to the credit cycle in a stabilizing manner... linking property-related taxes to property prices in order to damp their swings... regulators need to be vigilant in maintaining the process of deleveraging and preventing any new buildup of leveraged asset purchases, including for commodities. In the long run, we need to greatly reduce the degree of leverage in our financial system and it may be a good idea to make leverage respond inversely to asset prices and to put stabilizing mechanisms in the tax system."

The more relevant lesson from Gagnon is that when the leverage is minimal, as was the case when the technology bubble of 2000 burst with no apparent ill effects, loose monetary policy may be an option.

However, more fundamentally, it cannot be denied that the moral hazard arising from the inevitability of bailouts (one which has been amplified many times over by the very open willingness of governments to bailout the fnancial markets and the TBTF actors) will always incentivize financial institutions and players to over-leverage and run up unsustainably high risks. The need for stricter and automatically kicking in regulatory policies to control the build-up of leverage assumes greater significance.

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