Hi Raf,

From what I can tell we broadly agree on things here. Most of the disagreement is likely around how we are defining terms.

In my general view, a bubble cannot be “real” in terms of being driven by fundamentals. So the post I’ve popped up here is, in that context, discussing solely bubbles due to “irrational valuations” of the type you’re discussing.

In so far as central bank regulation around capitalisation and systemic risk – this is an issue that has to be looked at in terms of financial stability, indeedy. Our central bank has been on top of that for a while, even working to incorporate this through risk weightings prior to the crisis. It will be interesting hearing it discussed at NZAE this year no doubt.

Another reason I like to seperate these things out is because, if we are genuinely concerned about affordability considerations (namely the cost of a housing service), we should be facing that as a distributional/fairness issue through government policy. Trying to rope the RBNZ in muddies the water and just ensures that, in the end, the fairness issue won’t get the treatment society desires.

I didn’t say “bubbles are driven by an expansion of credit”. But the ones that are do create a systemic risk. If I could split the hair a bit more, I would argue that “real” bubbles reflect the simple emotions of greed and fear, where an asset appreciates well beyond any justifiable measures. Or in other words it shifts from a yield to a capital return. I buy it because I think I can sell it at a higher price, and not because I think the ongoing return on investment will be worth the risk.

Now, in terms of “credit” bubbles, I take your point that this may simply be a reflection of “real” bubbles but manifested through a demand for new credit with which to speculate with. Thus, the housing bubble is being driven by demand for housing as an asset class AND this is supported by the willingness of banks to create credit to finance this.

IF banks are appropriate capitalised, then fine, but my experience tells me that this hope is rarely realised when the trade reverses. Or as we used to say in the markets, “it’s all about funding, not about P+L” 🙂 So house prices are set by funding issues and not P+L issues (value).

I agree with your final paragraph. To restate my point, I don’t have an issue with bubbles but I do have an issue with systemic financial risk. When those two collide, we generally have a bad outcome 🙂

No I’m still pretty heavily convinced that we don’t need to differentiate bubbles in this way 😉 . Let me explain my view.

If the “bubble in credit markets” is showing up in asset price inflation for certain asset classes, then we are saying people are relatively willing to overpay for a specific asset class – and as a result, as long as we have a situation where banks are adequately capitalized then we are in the exact situation I was describing above. The “bubble” in this situation is driven by expectations.

If the bubble in credit markets is across ALL asset classes, then we again have a transfer across all asset classes from speculators to owners.

Any efficiency loss would arise from over-investment in the asset classes associated with the bubble. As a result, if the bubble is in all asset classes we are really just saying that we are investing too much out of income and consuming too little – this is an interesting line to take, but it does not justify any actions from what I can tell.

Also I can’t say I agree with the line that bubbles are driven by an expansion of credit – surely an “irrational bubble” is due to expectations of capital appreciation, which lead to an increase in demand, which lead to the process of credit creation (due to money being endogenous, and the central bank “setting the price” in the short term). Credit still has to be created by something, the quantity is just not “set” as the old monetarist view – with its focus on full reserve banking – used to place down.

If you reply saying banks can loosen standards etc etc, I agree, and this in turn leads to a appreciation in asset prices (as it is essentially equivalent to a lower interest rate). But this isn’t a “bubble” this is a structural element of the finance industry that leads to capital appreciation – and this is relevant only insofar as there are concerns about systemic risk. As we would both agree on here, this justifies regulation (around things like capital requirements) – but I would argue this is very separate from any discussion of fully defined “bubbles”.

i think we need to differentiate between a bubble in a specific asset and a bubble in credit creation. The latter is a normal market occurrence and involves actors investing resources into a particular asset, which increases exponentially in price. The resulting bubble and collapse results in a transfer of resources from buyers to sellers. Disruptive yes but not something that really should be an issue. Nick Smith complained vociferously about the outrageous profits on land-banking…but not so much about the outrageous increase in Xero’s share price (of about the same increase).

But bubbles caused by a direct expansion of credit are a different matter, primarily because the whole economic system is financed by credit. We have seen this in the portfolio effect of QE, with commodity and equity markets being blown up (not specifically in bubble territory but with similar characteristics). When housing is the asset class in question, the problem becomes bigger. There is nothing new in this (see Harrison, 2005, Boom, Bust: House Prices, Banking and The Depression of 2010) cycle but it suggests a structural flaw in the financial system. If house prices are driven purely by supply/demand issues, then again, that’s a matter for the actors involved. However, where credit is involved, it becomes a more systemic problem.

That doesn’t mean the RB or anyone else should be trying to “pop” a housing bubble but they need to spend a bit more time focusing on the financial structure and how it drives prices in different bits of the economy.

I’m not sure that is quite the full scope of it. I’d note that Hickey is in no way talking alone, a lot of people are unhappy about the high house prices, and the perceived impact on the affordability of housing. In that context, there is a policy issue, Hickey along with much of society is saying this is causing harm! That is good.

I’m just trying to point out that RBNZ actions to alleviate this harm may not much sense when we dig into them! And as a result, we need to instead dig deeper. On top of this, a bubble in of itself should make housing more affordable – by causing overbuilding and lowering rents – but this isn’t what is happening. This tells us something else is at work here!

The PTA mentions it here in the communications section:

“In pursuing its price stability objective, the Bank shall
implement monetary policy in a sustainable, consistent and transparent manner,
have regard to the efficiency and soundness of the financial system, and seek to
avoid unnecessary instability in output, interest rates and the exchange
rate.”

Indeed price stability and the soundness of the financial system will have a relationship – but it is the same sort of relationships that fiscal and monetary policy have. They are related to each other, but can be operationally separated (based on a series of different tools). Co-ordination is important, which is why we have the two roles separate but in the same organisation.

I don’t really understand what economic stability is – but you’ve mentioned it, and so have Blanchard and Stiglitz (among others), so it is obviously something I need to get into my head 🙂 . The issue for me is “stability with regards to what”. We have a changing world, with changing technologies and degrees of scarcity. We have a world where people make silly decisions and transfer each other goods and services for nothing. We have a world where sometimes the distribution of opportunity is unfair. I do not disagree that we can see these as policy issues – but they aren’t part of the mandate of a central bank 😉

If economic stability merely means something like NGDP targeting – then it does fall under the monetary policy framework. But bubbles still aren’t a monetary policy issue in that view 😉