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December 29, 2013 5:55 pm
Back in 2006 and 2007, commentators (including this one) warned about the rise in stock prices, housing credit and other forms of risky lending in several advanced economies. House prices are rising again. Stock indices have broken records. Derivatives with three-letter acronyms are back. So are long-forgotten old favourites, such as the “cov-light” loan (don’t ask). Should we be worried?
Not really. This time really is different. I do not mean that the world has entered a new phase allowing us to use silly arguments, such as a change in demography, to defend high and rising asset prices. My point is a different one: if some of these bubbles burst, as they undoubtedly will, I do not see similarly devastating effects as I did last time.
For starters, what matters for economic stability is not the level of asset prices, and their subsequent deflation, but leverage and contagion. By 2007, several advanced economies had reached the final third stage in Hyman Minsky’s financial instability hypothesis. This was what the famous economist called Ponzi-finance – a snowball-type financial racket that was bound to end badly. The bursting of the bubble triggered bank failures, which in turn had contagion effects throughout the financial system. The US subprime mortgage market was, of course, the most extreme case of late-stage Ponzi-type finance, which ultimately triggered a near-meltdown of the global financial system.
In the UK, Northern Rock funded house purchases with a loan-to-value ratio of well over 100 per cent of the purchasing price. Loan-to-value ratios are rising again, but not yet to levels that are remotely dangerous. It is right that the central banks keep an eye on these exposures. But with all the changes that have taken place in global banking supervision and regulation, it is hard to imagine that we are going to see even a remote rerun of the US subprime crash. I would acknowledge that the rise in UK property prices is credit-driven. I also find it hard to see how UK house prices could rise by much in real terms from the current levels in a sustainable manner. But even the return of a 95 per cent loan-to-value ratio would not be scary in itself. The UK has been there before.
The second reason I am more optimistic is that there is a greater consensus among central bankers in favour of using macroprudential tools. In several markets we may be in a late-stage one or early-stage two of the Minsky financial instability cycle – somewhere between what he calls hedge finance and speculative finance. There are signs of unusual risk-taking. The instruments of choice to control a housing bubble, for example, are loan-to-value caps and property transaction taxes. Since the dangerous type of housing bubble is credit-driven, a capping of loan-to-value ratios would be particularly effective.
And finally, the upturn in the business cycle in the US and the UK reduces to some extent the conflict between economic stability and financial stability. It has been necessary for central banks to keep policy interest rates low to prevent deflation and stabilise employment. If low nominal interest rates persist for long periods, we know that they tend to encourage financial speculation. As the business cycle in the advanced economies turns upwards, interest rates will begin to rise. There will be less incentive for speculative borrowing then.
I am aware that the interest rate tool alone is far too crude to control economic and financial stability simultaneously. Even if the US Federal Reserve and the European Central Bank had run tighter monetary policy in the earlier parts of the past decade, they could not have stopped the subsequent bubble, although arguably they might have reduced the collateral damage somewhat. But if you combine a rise in the cost of credit with macroprudential policy you should have all it takes to control a housing bubble.
The probability of a rerun of what happened in the past decade is thus comparatively low. But beware: history is the study of events that do not repeat themselves. There are different types of financial instability that may arise this decade. Watch out, for example, for instability arising from global financial flows, including through mismatched foreign currency borrowing.
The single biggest risk to global financial stability remains the eurozone. The present calm is deceptive. Regular readers know that I see the eurozone heading towards a moment of truth at some point in the next few years for which it will not be prepared. The date is impossible to predict. What we do know is that each time the crisis subsides, the EU’s leaders become complacent: the botched banking union is the latest example. If you are on the optimistic end of realism, you might believe that a debt conference would negotiate an orderly managed default. But our experience of negotiated settlements in the eurozone is that negotiations never produce a full resolution. While several scenarios are plausible, it is hard to envisage one that does not produce further serious risks to financial stability.
So watch out for those global macro imbalances as the main threat, plus mismanagement of micro-imbalances in specific sectors and countries. Financial bubbles may all have a similar underlying dynamic, and like Tolstoy’s unhappy families, they are each calamitous in their own way. But not all of them matter.
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