I’ve been seeing a lot of the following around the place:

Looks pretty scary right – red columns go lower than during the Global Financial Crisis :O

However, these big red columns are a bit misleading. The data is true – financial institutions holding government bonds have made large unrealised losses on government bonds due to the surge in interest rates. But there is a reason that financial regulations don’t make banks recognise these losses.

Now I don’t know much about much, so I’ll talk through some of the basics of how these things fit together and how I understand it. When there is something important I’ve missed feel free to point it out – but I think after the discussion we’ll at least be in a less misleading place than “giant red bar on Twitter”.

tl;dr: Unrealised losses on government bonds for banks are not really a concern. The real concern would be if there was a genuine increase in bad debt/default. However, the existence of these unrealised losses may make financial markets more sensitive to shocks.

A stylised bond

Imagine a world where you are deciding what to do with a spare $100 you have sitting in your pocket – and you’ve made a decision you want to save it to spend in a year.

In this make pretend world you have four options:

1. Change your mind and spend it – if the product is durable you could sell it in the future.
2. Hold the cash.
3. Pop the cash in a bank and earn interest.
4. Purchase a fixed-income instrument that matures in a year – i.e. a government bond.

To keep things simple, lets focus on your choice among the last two – say because the things you can buy are really expensive to store or resell, and cash is expected to fall in value through time due to inflation.

If I pop the money in the bank, then a year later I get it back with interest. Lets assume an interest rate of 5%, that means that in 1 year I have $105. Nice.

Now say that there is a bond sitting there that is completely riskless. It costs $100, pays me a $5 coupon during the year, and at maturity will pay me $100 (the face value). Well buying this bond involves saving $100 now and receiving $105 in the future – so it looks like the same thing, with a 5% interest rate.

If interest rates suddenly doubled the equation changes. The doubling in interest rates mean that, if I put the money in the bank I will end up with $110. However, in the bond example I have $105. As a result, I’m not buying the bond – I’m going to save the money.

In fact, a lot of other people will do the same thing – reducing demand for bonds. People will be willing to sell the bond until the yield on the bond (amount received in a year divided by the amount paid now) is the same as the interest rate. As the coupon payment is a fixed amount of income the price of the bond must adjust.

This implies that the price of the bond must decline to around $95.45 (since this amount plus 10% is approximately the $105 received in a year).

Now assume that the interest rate occurred after I had purchased the bond. In this case I am holding a bond that I paid $100 for, but the price has fallen by 4.5%!

In one sense I have lost money – if I went and sold the bond right now to consume right now, I would have less than the $100 I started with.

In another sense, nothing has happened – if I was always going to wait to maturity I am going to end up with $105 in the future, just like I was anticipating before the interest rate change. In this way I haven’t lost anything and my financial situation is purely unchanged.

If bank are just holding these bonds to maturity – in the way they are with other loans – then these losses don’t effect anything, they are just paper losses. However, if they intended to buy and sell the bonds as a means of liquidity management in the here and now this wouldn’t be so good.

Is this a concern?

According to people on twitter the sharp drop in the market value of bonds is a concern. Why? Big red line mate – time to load up specifically on my crytpocurrency.

To be more specific, the inference is that this unrealised loss is still a loss – just like individuals defaulting on loans, this should be seen as a reduction in the value of assets of the firm.

A reduction in the value of assets implies that – at a point in time – a bank will have less available to meet its liabilities (i.e. our deposits at a bank). This could play out in a couple of ways:

1. Since assets = liabilities + equity a sharp drop in the value of assets may make the net equity in the bank negative – making it insolvent!
2. Even without insolvency, if concerns about these unrealised losses led an increasing number of individuals to withdraw this would run down banks liquid reserves, and increase the chance they have to sell bonds and realise the loss – leading to a self-fufilling bank run.

The first case is a pretty much non-issue. As noted above, if the bond is held to maturity an unrealised gain or loss is just a “paper” change in value – it does not change the real financial situation of the bank.

The issue only occurs if the bank is forced to realise this loss.

So say there is a sharp increase in demand for funds from depositors, how does this play out.

• Seeing that there is an increasing demand for funds, retail banks need to meet this.
• If inter-bank lending is also limited (due to other banks feeling similar pressure) the bank will feel tempted to use their bonds to gain access to liquid funds to meet this demand from depositors.
• They can do this by borrowing from the central bank, using the government bonds they hold as collateral.

Recently an RBA assistant governor even gave a speech about how all of this works – give it a look!

Summing everything up – these unrealised losses on government bonds for banks that are the topic of twitter are not really a concern. The real concern would be if there was a genuine increase in bad debt/default.

However, in a world of uncertainty where there are certain triggers for default (rising unemployment, structural reform in China and their housing bubble) the concern about unrealised losses can make financial markets a bit more fragile to these shocks – something that financial regulators will be keeping an eye on.

There are many other examples of low lying fruit in the policy domain where a combination of entrenched interests and innate conservatism inhibits movements to welfare enhancing changes (eg a flat tax/guaranteed minimum income tax benefit system, redesigning GST on a origins basis, and global free trade).

The claimed benefits of adopting the Chicago Plan are truly profound, and if true would have a larger impact on the welfare of New Zealanders than most other issues that dominate political debate.

It would seem to be a good use of government resources to have this issue investigated thoroughly to, either put to bed the claims if they are illusory or to begin implementing a change if they are indeed genuine.

The potential benefits David notes are:

1. Having to obtain outside funding rather than being able to create it themselves would reduce the ability of banks to cause business cycles due to potentially capricious changes in their attitude towards credit risk.

2. Having fully reserve-backed bank deposits would completely eliminate bank runs, thereby increasing financial stability and allowing banks to concentrate on their core lending function without worrying about instabilities from the liabilities side of their balance sheet.

3. Allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances.

4. Allowing a reduction in private debt levels as money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets.

5. It generates long term output gains from a lower interest rate profile, lower tax rates (as the government can earn more from seigniorage), and lower credit monitoring costs for banks.

6. It can allow steady state inflation to drop to zero without posing problems on the conduct of monetary policy. A critical underpinning to this result is the greater ability to avoid liquidity traps as the quantity of broad money would be directly controlled by policy makers and not dependent on bank’s willingness to lend, and because the interest on Treasury credit would not be an opportunity cost of money for asset investors, but rather a borrowing rate for a credit facility that is only accessible to banks for the specific purpose of funding physical investment projects, it could become negative without any practical problems.

This does sound to good to be true.  Hence why, as always, there are trade-offs.

In this case, there is full reserve banking, and people’s liquid deposits actually are available for withdrawal “on demand”.  As a result “bank runs” become impossible.  However, since the funds cannot be lent out, the rate of return on those funds would disappear – in fact banks would be simply charging people a service fee to give them a safe place to hold their money.  This implies that charges for saving with the bank will rise.

It is terms deposits that could be lent out, for an equivalent maturity of investment – as a result “maturity mismatch” would disappear, but the advantages of “maturity transformation” would be lost in the regulated banking sector.  Note:  Equity financing would allow banks to lend out funds, and the switch to equity financing could well be seen as a plus!

As a result, the fact that currently accepted forms of banking would be banned would imply that they move into the “unregulated” banking sector – potentially increasing the risk of financial crises rather than increasing them.

Timing effects also matter.  If banks funding will move with the economic cycle in a lagging way (and as lending is pinned to funding in this case, so will lending), and as a result their ability to lend will be as well.  In this environment, it seems a bit of an overstatement to say such constraints will get rid of the business cycle.

Furthermore, the details of the transfer associated with the plan matter – if the shift to reserves through government intervention and corresponding seinorage is a implicit one-off tax, people will lose some trust in government and may expect similar tax grabs in the future.

Remember, high debt levels have downsides, but they can also be a sign that very heterogeneous lenders and borrowers are meeting in the marketplace – the DSGE framework doesn’t capture this, and the associated costs are as a result being ignored.

Do you agree the plan – which would cleanly separate the “deposit holding” function of banks from the “lending and credit creation” function is a good idea?  Are these potential downsides too much?  Or do we simply need more details before we can decide?

Intro

I’ve been asked to talk about the ‘mistakes made’ with regards to the Global Financial Crisis, and the ‘financial architecture.  Let us start off by not assuming a mistake per se, but in asking what type of narrative describes what we experienced – from that we can try to describe what can be seen as a mistake.  Furthermore, the term “architecture”, or “infrastructure”, also presupposes something about the nature of financial institutions – and directly implies it is something that needs to be built, making it sound as if we need a central organisation to do it.  While there might be some truth in that, it is not where I’d prefer to start with any discussion.

Focusing on supranational, undemocratically determined, institutions for “solutions” to a policy problem misses the point – yes the world is integrated and national level institutions need to coordinate more, but focus needs to be on national policy when discussing mistakes.  As Dani Rodrik says, it is up to nations to keep their house in order, not other countries.  If anything the crisis in Europe shows the shortcoming of supranational regulation, given the true democratic mandate is a national one.

Even after a crisis the key thing we need to ask is what narratives fit our data, so we can build an understanding of what the impact of (national level) regulatory policy could be.  For an example of how this matters, say that if a financial crisis is like an earthquake – in that case we may believe that policy actions that help to insure people against the costs are appropriate.  Instead, assume that a financial crisis was due to the risky choice of individuals and organisations – then we would want policy that makes these people bear the costs of their choice.

The “truth” is between these, so let’s talk about these narratives.

The financial system

The GFC should not have changed our view of broad view of what financial institutions are.

The purpose of the financial system is as a market – as place where individuals and groups who want to save match up with individual and groups who want to borrow.  The institutions in the middle are financial intermediaries – and their role can be viewed in a number of ways:

1. By screening the quality of borrowers, and doing so with the economies of scale of a large institution, they provide a cost effective service for those who want to save.
2. Due to their scale, financial institutions are able to diversify risk – which individual depositors may not be able to do if they lent directly.
3. Maturity transformation:  Financial institutions, due to their size, are able to “lend for the long term” and “borrow for the short term” as long as depositors have faith in the institution – this ‘maturity mismatch’ creates value for both lenders and borrowers.

There are broader points about banks offering a ‘risk-free rate of return’, determining the money supply, inflation-protection of savings, and offering financial services – these are important issues when thinking about regulation, but are a bit beside the point when we are focused on the GFC directly!

The question we are focused on is around the “mistakes” made by policy during the Global Financial Crisis.  We can split mistakes into two categories:

1. Mistakes in terms of policy during the crisis.
2. Mistakes in terms of regulation and policy in the lead up to the crisis.

This separation is very important, as it helps to give us a perspective on the way policy and institutions can be changed to reduce the chance of a similar crisis – and also helps us to think about the cost of these regulatory changes!

The catalyst of the crisis

When thinking about the crisis kicking off, a lot is made of subprime mortgages, and non-recourse mortgages (so the debt is against the collateral in the house, not pinned to the individual borrowing).  Although housing is an important asset class (and the structure of mortgages did influence the way the market adjusted), it is more useful to think about these events in more general terms if we want to consider the financial infrastructure more generally.

• Lehman Brothers and the failure of AIG
  • Crisis had kicked off in mid-2007 with the housing market slowing in the US and BNP Paribus (in France) running into a liquidity crisis in August.
  • Northern Rock in February 2008 and the Bear Sterns event in March 2008 – still debate about whether the bailout exacerbated risk taking in the lead up to September, or whether it did prevent a crisis as of March.
  • Failure of LB after Barclays refused to buy at the last minute in September 2008.  Led to the near failure of AIG, an insurance company that had essentially been insuring a sizable chunk of the shadow banking system.
  • “Oil price shock”.  The steep run up in oil prices during 2007/08 was also a major, and often underplayed, cause of the global recession in late 2008/early 2009.  The magnitude of this shock was underplayed at the time, and was part of the reason why the slowdown heading into during 2010/11 was also more intense than anticipated (oil prices were rebounding at this time).

The response

After it became apparent that the failure of Lehman Brothers had done irreparable damage to AIG, faith in the entire financial system collapsed.  The rapid nature of the response by global economic authorities is captured in a book called “the alchemists” by Neil Irwin.  This gives a good run down of what happened through the narrative of the US, UK, and European central bankers at the time.

A combination of monetary policy easing, currency-swap agreements between central banks, significant new liquidity facilities (eg accepting lower quality collateral when giving loans), and direct purchases of some institutions (where shareholders value was essentially wiped out – but bondholders retained their claims) were all implemented in the wake of the Lehman Brother’s crisis.  Together, these policies helped to stabilise the financial system.

Fragile by design or nature?  Why not both.

The response to the crisis was largely appropriate.  Actions by the Federal Reserve and US Treasury helped to stem what was a “bank run” in the shadow banking system.

Shadow banking system:  “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions – Bernanke”

The idea of a bank run in the shadow banking system was popularised by Gary Gorton.  He noted that one of the key reasons the crisis had such a broad impact on the financial market is because of the nature of shadow banking, and the way the line was blurred between commercial and shadow banking – namely that commercial banks would use the shadow banking sector for a significant amount of their interbank lending and borrowing activity.  One of his views was that the shadow banking system evolved to avoid regulation (rather than being the result of lax regulation per se) – which gives him the conclusion that we simply need to extend regulation to capture the shadow banking system.

Of course, this is far from easy – trying to regulate a specific industry is like trying to squeeze a lemon with your hand and keep it contained, the harder you squeeze the more bits leave your hand completely.

When faced with a bank run in a situation where large parts of the financial system are inherently “solvent” but facing problems of “liquidity” a government can improve outcomes by saying they will not let the organisation fail.

Illiquidity:  When an institution would, if holding its assets to maturity/selling at a ‘normal’ point of time, would be able to cover its liabilities.  However, during a crisis the institution is unable to sell its assets at a sufficiently high value to meet its liabilities.

Insolvent:  When an institutions liabilities would exceed the value of their assets in normal economic circumstances.

A bank run leads to a coordination failure for solvent firms with liquidity issues – if people were not pulling their funds out of a solvent financial institution, then it is in investors interest not to take out their money.  But if everyone is taking out their funds, the institution is forced to sell assets at “firesale” prices, making it in the investors interest to pull out as soon as possible!  This illustrates that the importance of the bank run is closely related to the idea of maturity transformation (or maturity mismatch) discussed above!

Note:  It can be hard to separate the two – given that insolvency may only become clear during a crisis!  When Bagehot came up with this in in the 19^th century he was clear that insolvent institutions should be allowed to fail, but modern regulators realise judging who is “insolvent” is unclear.

Mistakes leading up to the crisis?

However, we can’t just think of these issues at a point in time – the existence of a guarantee in the case of failure changes how we all view institutions.  If such a bailout is expected, depositors with financial institutions are willing to accept a lower rate of return – as a result, the entire financial system ends up taking on more risk.

This is a version of “moral hazard” and stems from the financial system (and depositors) being implicitly or explicitly insured by central government.

While there is this policy view of risk, there is also the more general ideas of “externalities” and “systemic risk”.

The key concern here is, even if firms were appropriately taking into account risk, they do not take into account how their failure could impact upon other institutions.  In this case, there are two issues of note:

1. A type of externality where the risk taking of one financial institution negatively impacts on other institutions.
2. A “cascading failure” in financial institutions due to the interdependence of firms – implying that in the face of a “systemic event” the failure of one institution could lead to the failure of the entire financial system.  This is similar to the idea of bank runs – and again a clear difference between “liquidity” and “solvency” needs to be taken into account.

However, it is clear that the policy and the market risks play off each other – the general unwillingness of policy to let institutions fail incentivises risky lending which makes the financial system more fragile, both in terms of having “too big to fail” (TBTF) firms and “too interdependent to fail” (TITF) firms. [Note this is very different to the Great Depression, where it was the fact firms were too small, and so were all treated the same independent of actual quality, that helped drive mass bank runs – these issues are often unclear!].

We can only say there is a “policy mistake” if we are clear about the goals of policy.  There are some key points that come from our narrative:

1. Some of the advantages of financial intermediation also increase fragility – implying there is, along some margin, a trade-off between efficiency and stability (eg maturity mismatch)
2. Although we have split the failures into three categories (regulatory, externality, systemic event) the three are intrinsically related and can feed off each other.
3. We need to be clear about the difference between insolvency and illiquid institutions – financial institutions should be able to fail, and if an entire financial system was “insolvent” the decision about what to do is actually a conversation of who should bear the burden for the loss.
4. More generally our “pre-emptive” solutions depend strongly on what we believe the cause of the crisis is – if financial firms require regulation, regulation should be tied strongly to a perceived failure.
   1. In this context, clear capital ratios for banks have attractive properties – current policy about matching maturities, LVR limits, core funding ratio, risk-weighted capital ratios all justified in this light.  However, questions about how much the central bank should be “determining risk tolerance” for private institutions – something that makes the Admati & Hellwig (in The Bankers New Clothes) suggestion of a general capital/equity ratio more attractive, as it is based largely on the view that it is the “favouring of debt financing to equity financing of lending” driving a lot of the issues down the line (TBTF, risky behaviour).  Eg firms have the incentive to become TBTF solely because of the implicit subsidy on debt financing, through the lender of last resort and tax status of this funding.
   2. However, capital requirements will still lead to excessive risk taking – although they may be helpful they are not the silver bullet that some may claim.  A recent paper by Josh Hendrickson (http://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2014/2/v34n1-7.pdf) points out that one of the key issues is to ensure that bank shareholders face losses that are commensurate with the risks they took on in the face of a negative outcome – his suggestion is to replace limited liability with contingent liability.
   3. Note that Josh’s suggestion would help to deal with the typical moral hazard issue, but not necessarily with the fundamental issues of systemic risk – and expectations of a policy response in the face of a systemic event (which then leads us back to moral hazard).  It is along these lines that the RBNZ is trying to clarify rules with the Open Bank Resolution.

An inability to get lenders and borrowers to see eye-to-eye:  The case of Europe

However, the crisis did not end up finishing at this point.  After the global economy recovered sharply during the second half of 2009, events in Europe took a life of their own.  There are two clear narratives that given for the fact that global economy continued to struggle in the intervening five years:

1. A failure of monetary/government policy.  This includes the delays to implementing forward guidance, the fiscal tightening in a number of countries, and the issues of “coordination” with regards to policy between countries.
2. Policy and regulatory failure in Europe that kept acting as surprise “negative shocks” for the rest of the world.

The European Crisis was in many ways a different beast, as the concern was about whether individual nation’s government would pay bondholders.  An unwillingness to define whether the burden of “bad government debt” would fall upon bondholders, bank shareholders, or taxpayers created a situation of uncertainty – and led to a seizing up in financial markets.

Disappointingly, the events in Europe didn’t teach us particularly more about the Global Financial Crisis.  Instead, the primary additional (and extremely costly) lesson of the European Crisis was simply that the institutions involved in European governance are weaker than we had realised.

David covers a range of concerns about LVR’s in his piece, however he is also concerned about whether having a central bank use such policies is appropriate and whether it is really a reasonable part of their mandate:

First rather than addressing the tax-related root cause to an excessive demand for home ownership it is trying to curb demand by introducing a new set of regulations. If you cannot change the tax rules then there may be some merit in a LVR scheme, but the result will invariably be worse than an approach that directly addresses the tax design issue.

The second issue relates to one of the political mandate for the LVR regulations.

Tax laws are determined by government and parliamentary votes.

If it is the political will to have a tax system that favours home ownership, what is the political mandate for a non-elected body like the Reserve Bank to introduce regulations to “protect” people from taking advantage of these tax rules?

Ultimately the Bank is imposing highly selective regulations that are limiting free choice and redistributing wealth across society.  These are the type of actions that normally require a political mandate, and it is not obvious that the Bank possesses this mandate.

Unlike the elected government, we do not have the recourse to vote out the Reserve Bank Governor at the next election if we are not happy with the Bank’s performance.

A very important point, and one a lot of economists out there (including the economists at the RBNZ) are puzzling over.

Mortgage approvals rose between the announcement and implementation dates, but have fallen sharply since then.

Mortgages approvals are closely correlated with house sales. Which in turn lead house prices. The LVR restrictions appear to be having the desired impact.

Many banks have pulled their mortgage approvals (in the media: ASB, BNZ and Westpac).

The question for the RBNZ is, is it temporary or is it a harbinger of a bigger change in borrowing and housing market movements? IMO its still too early to tell.

1. Reserve Bank.
2. Treasury.
3. MBIE.

Linking is not approving.  I’ve gone through the documents and didn’t agree.  There was no evidence to sway me in any of these documents, so my views have not changed since I last discussed bubbles, limits on foreign ownership of housing, my concerns that financial stability is being abused as a concept, or NZ LVR policy (here and here as well).

We rely on markets (with appropriate competition policy) as we cannot observe the things people value.  Within an insurance framework, there is scope for financial stability policy, and active monetary policy – but it should be clear and rule based.  It should not be the direction we are going.

That is my view, I hope I am wrong and that I am persuaded otherwise.  I will actually be switching the topics I write about next week – income distribution and income inequality will be almost all I’m posting on.

On this note, Cochrane is supporting the idea of a externality tax for banking:

I think a simple tax is the answer – though since “tax” is a dirty word, let’s call it a “systemic externality fee” – on debt, and especially on short-term debt or any other contract where the investor has the right to demand payment, and fail the firm if not received.  Every dollar of such funding will cost, say, a 10 cent fee. Payments due later generate smaller fees. I think we’ll see a lot less run-prone debt, fast. (We could at least stop subsidizing debt!)

Then, we won’t have to argue about risk weights and precise capital ratios, we won’t have to intensively regulate bank assets, we won’t tempt regulatory arbitrage, we won’t ask the Fed to decide whether houses in Palo Alto are a “bubble,” we will not hear the periodic call “we must recapitalize the banks” (at taxpayer expense), and, most of all, we can escape the chokehold on competition and innovation posed by our current expanding regulatory mess, together with the capture, cronyism, and politicization to which it is swiftly leading.

We need a financial system that can absorb booms and busts without creating a run or a crisis, rather than dreaming that regulators can produce a world without booms and busts. We need to regulate financial institutions’ liabilities, not micro-manage their assets, and especially not try to manage the price of every asset in which they might invest. We must escape this crazy system in which our government subsidizes debt, guarantees debt, increases the demand for debt by regulating it as a safe asset, and then tries to regulate financial firms away from issuing that debt.

Indeed, this is more consistent view of the entire financial stability issue – hence why I agree

I disagree with this piece.  But, it is well laid out and argued – which makes it a good piece!  So let us go through the reason why I take issue:

1) They are advocating one tool, many targets.

If the excess becomes a systemic threat, the Fed should then address it through its (existing) powerful interest-rate levers.

Although they seem to do this for nice enough reasons:

We are not advocating expanding the Fed’s tool kit and do not think the Fed should micromanage the economy.

It still doesn’t make sense.  They are trying to assume away some of the costs directly inherent in trying to get the US Fed to do what they want, by just not giving them the tools to do it!  The number of tools needs to be equal to the number of targets (here, wiki of Tinbergen), so if you aim to target some functional relation of financial stability as well as inflation we need these macroprudential tools!

Admitting this, and ensuring the institutional structure is appropriate for the given tools and targets is important.  When discussing having monetary policy and financial stability policy it was justifiably stated on VoxEU that:

Institutionally, it can be advantageous to assign both policies to the same authority, namely the central bank. However, safeguards are then needed to counter the risks of dual objectives, and institutional frameworks should distinguish between the two policy functions, with separate decision-making, accountability and communication structures.

2) The suggest attacking bubbles as part of an employment mandate – as a popping bubble lowers employment

Yet when financial excesses are building and not accompanied by inflation or unemployment, the Fed is unlikely to act. We need not accept this inaction. Fed governor Jeremy Stein, who has been writing on bubbles, said this summer that deflating a bubble would be consistent with the goal of promoting full employment because a bursting bubble affects employment.

Is the Stein argument a good one?  Is the Borio argument a good one?

It appears a growing number of central bankers think so as well.

But I find it uncompelling as it is confusing policy related and unpolicy related costs from bubbles!  A bubble ‘pops’, implying that some people that purchased the asset at a higher price lose out – this is NOT policy relevant.  A bubble ‘pops’, people default, a bank is about to fail and drag everyone down with it.  This is a concern.  But understanding why the other banks are not sufficiently insured against this failure, and why a bank is fragile to the “popping of a bubble” that is supposedly so obvious is important here – the ideas of systemic risk, and the fact that current regulations act as a subsidy on borrowing for banks is the main issue here. NOT the popping of some ‘bubble’ itself.

So far the only argument I’ve seen for directly targeting bubbles is “its obvious, look at the crisis”.  This is a bad argument.

Note, none of what I’m saying disagrees with this:

we were almost unanimously blind to the risks of rising housing prices and bank leverage

But it just states that we should think about where the issue, and concern, with systemic risk comes from.  It is the idea that, in the face of a shock, our financial system would fall over – a financial system that won’t be allowed to fail, and in turn is willing to take on excessive risk.  Our solution should be based on this itself – not using interest rates to target financial stability.  And in practice this still doesn’t make any sense unless we are willing to stick our neck on the line with a “model” of the bubble, and an ability for ex-ante identification, which can be used to make the policy action transparent!

And it doesn’t really disagree with this:

The simplest way to encourage Fed governors to be vigilant for excesses is to make maintaining financial stability explicitly part of the Fed’s mandate. This would have two effects. First, governors would be required to search, proactively, for imbalances. In essence, Fed officials would have to approach the economy from a different perspective than would most Americans.

Except that I ask us to think about this more carefully.  If we are mandating a specific regulatory role, why do we have to mix it up with monetary policy?  Why can’t we simply have two organisations with independence and a mandate signed by the finance minister.  Hell, make it three organisation and do it with tax as well

The fact is that financial stability is a different role.  Yes monetary policy (and fiscal policy) influence it, but it is a separate target.  If we justify a target on public policy grounds, and if that target is subject to dynamic inconsistency, and requires clear communication, then we SHOULD have a clear independently set mandate for an independent organisation on that basis.  That is the kicks.

And for financial stability this is the real big kicker for me – can we at least make an attempt to come up with a clear target and to justify it on policy grounds.  Rather than throwing around heaps of nifty ex-post justifications for doing things, which inherently lead us to move towards discretion, political interference, and micromanagement

But anyone who reads TVHE knows what I’m like, I just really really want to know ‘why’ certain things are being said!  I emailed a few economists and some suggested I do a bleg asking, so why not!

In the Yahoo story there are a couple of segments I’m a touch confused on and I’d like it if someone could answer them for me  (Note:  Seamus from Offsetting offers some example answers at the bottom of this post)

Grimes said investors were still likely to pile into asset price bubbles because they expected that even if they burst, central bank action to support the economy would soon cause asset prices to return to their previous levels.

On the face of it this is a type of moral hazard argument where we have “implicit insurance” of asset prices by the central bank, leading to excessive risk taking, and weakening market discipline to prevent “bubbles”.

But let us think a little further, if the central bank is ensuring stability in the price level in a way consistent with closing the output gap/keeping unemployment near some natural level I’m not sure I see the issue.  Don’t we need to answer the question of why the relative price of assets to goods and services remains elevated due to central bank action?

Furthermore, if an asset price collapses with economic activity and then rises back to its prior level with economic activity was there really a “bubble” – can we really even say the “bubble” popped.

I don’t know what his “model of bubbles” is.  But I also know Grimes is insanely smart, so I was wondering if you have any idea of what the mechanism in this is?  What are we calling a bubble here, the rate of return on assets being lower than we think is reasonable, or is it due to expectations that are out of line with reality?  And where is the economic cost of this – if the volatility in asset prices merely causes a transfer between participants who cares.  After all we can’t just draw a straight line from asset prices to economic activity without asking “why” about the bubble – the ‘tech bubble’ and the ‘housing bubble’ were quite different beasts for example.

We may use some type of structural insurance argument.  My guess is that view in the above quote may involve implicit commitment by the Fed holding up asset prices relative to their fundamental value, therefore leading to excessive investment and greater borrowing for a given level of goods price growth.  But here the “asset prices back to their previous level” call makes no sense to me – as this implies that the relative price of assets is also returning.

Either this is an inconsistency, or I’m not sure if I buy this model of bubbles … as implicit insurance IS one of the drivers of fundamental value.  I really need a “model of bubbles” before this makes sense to me and I just don’t know what it is.  Furthermore, this is increasingly sounding like a structural issue rather than a monetary policy issue – as there is nothing inherent in stabilising the price level and closing the output gap that would imply asset prices will be ‘propped up’.

Note:  The model of bubbles matters.  We need it to understand policy.  And as Shiller, Sumner, and Gali have all noted this is a very difficult issue that doesn’t fit into a single box named “bubble”.

And then in terms of the conclusion.

“They are stuck between a rock and a hard place, in terms of the Fed officials themselves. You would have to have a big bang to say: ‘We are targeting price stability. We are targeting stable asset prices as well as stable goods prices.'”

Stability in asset prices?  How does saying you will keep asset prices stable reduce the moral hazard issue – doesn’t it increase it by directly taking on systemic risk in asset prices.

Is this really something we should announce with regards to monetary policy?  How do we judge “stability” in this way, given that movements in asset prices as an aggregate are a useful piece of information about monetary policy (given their flexibility, and the fact that are made up of forward looking expectations about nominal returns).

Note that asset prices that are “too high” are an indicator that monetary conditions are “too loose”.  Is the complaint that monetary policy in the US tends to be too loose here?

And lets not even get started on trying to measure aggregate asset prices through time … that is an even stickier issue than measuring goods price

What’s the bleg

I was just wondering what is being said in this article, and why.  What is the bubble mechanism being used?  What is the implied criticism of Fed policy?  In what ways does this imply that Fed policy should change?

On the face of it, I just don’t see the argument against simply targeting goods prices and closing the output gap (or NGDP targeting if you are that way inclined) in this piece.  And given the Fed has been easing policy INSUFFICIENTLY on this basis, the argument that their policy has been too loose also wouldn’t make sense.

Seamus Hogan’s answer

After I finished this post, but before I popped it up, Seamus from Offsetting Behaviour flicked me the following answer, and said I was allowed to pop it up here.  It offers a good framework for us to think of working through this question.  This was just a quick answer as him and Eric are a bit short on time to post a full discussion on it right now.  They were happy for me to pop it up here though!

My first pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. But at the same time that policy mitigates the extent to which the asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, why are we worried about the bubble in the first place?

My second pass:

1. Asset bubbles are bad because when they burst, they cause damage to the economy.
2. However, when they burst they are bad for those caught buying at the end of the bubble.
3. The central bank can use monetary policy to mitigate the damage to the economy.
4. This policy will only partially undo the damage to the economy, but will heavily mitigate the extent to which asset prices fall.
5. Therefore, unless the central bank can credibly commit to not helping the economy, speculative investors will know that there isn’t much downside to buying up assets as their expected value has been elevated by dampening the prospect of a bad economy.
6. In which case, the inability to commit to not slightly help the economy in the event of a damaging asset-price-bubble burst will heavily increase the risk of such a damaging burst happening, and so the expected cost of future bubble bursts will be higher than in the case where the Bank could commit to letting the economy languish in a recession.

The two differences in these logic steps are in red. The key is whether the change in Point 4 makes empirical sense. If so, there is still an empirical question as to whether the relative magnitudes make point 6 in the second pass make sense, but the blogging point needs to rest on point 4. I’m not sure I buy it. I can buy that the Fed’s only help-the-economy-strategy—printing money (QE) or lowering interest rates can easily lead to leveraged portfolio investment rather than fixed investment, for some settings of expectations; I am having a hard time seeing how, though an asset bubble burst that largely goes away because of Bank policy can harm the economy.

Where I disagree

The purpose of the new rules is to reduce the amount of risk accumulating in the banking sector. The RBNZ’s aim should not be to reduce credit growth or house price growth per se, rather systemic risk arising from high risk debt that may have implications for financial stability, and in turn, economic stability. But it feels like the RBNZ is really targeting house prices.

The RBNZ should keep the financial stability tools as separate from monetary policy as possible. Focussing on risk in the financial system in a consistent manner would keep monetary policy independent/free of political interference. Politicians will be running interference with this policy – as we have already seen from National, Labour and Greens. This political interference should be a good reason to ask if the RBNZ should be doing both monetary policy and financial stability.

I take issue with the amount of discretion applied by the RBNZ, as Matt noted earlier. If there is systemic risk because of high risk loans, they should be using these rules all the time, rather than trying to massage things and cute market timing. To change rules on an ad hoc basis creates unnecessary uncertainty, which is costly for people making plans.

If too much credit is a bad thing, make banks hold more capital. If too high LVR is risky for the banking system, create a limit for how much of this stuff banks can hold. But to say somehow the RBNZ knows best how much credit there should be in the economy at any one point in time, or what type of credit or for what sector – has all the hallmarks of hubris and central planning on a grand scale.

It makes me shudder. Is no one else scandalised by this?

I see Rodney Dickens is. Good on Rodney for making some important points – its a good read.

Now for some relevant, toned down opinions on what is actually going on:

The new regulations

The new regulations are:

1. 10% of new mortgages can be high LVR (80%+), from 30% now.

2. The RBNZ has also increased the correlation factors for high LVR mortgages, meaning banks will have to hold more capital.

Already biting

The restrictions are already biting on new borrowing. There are two really good articles on interest.co.nz on this by:

1. David Hargreaves on how the banks have already taken notice

2. Bernard Hickey on reduced new home purchases by high LVR buyers

Changes in bank behaviour

It is not surprising to see why the RBNZ was worried about bank behaviour. A rather large portion (41%) of the growth in the big four banks’ mortgage books ($10b over the year to June) was high LVR.

There are some changes in behaviour already.

ASB pulled its pre-approvals for high LVR mortgages, even though they have three months to comply with the RBNZ’s new rules. ASB was perhaps caught on the hop with too much reliance on high LVR lending to grow its mortgage book.

I expect banks also to be much more aggressive in hunting out ‘traditional’ mortgages, possibly with lower margins. Banks still want volume growth. So this will not necessarily reduce total credit growth, as the RBNZ wants.

Changes in borrower behaviour

There will be changes in borrower behaviour. There is the inevitable gnashing of teeth by those who have worked hard to save a 5% deposit, but some will circumvent these rules by borrowing from mummy and daddy, or lenders not covered under the regime.

Richard Meadows of Fairfax does a slightly tongue in cheek look at the alternatives.

The last word

I think the RBNZ has chosen a cute market timing approach with macro prudential tools. Market timing is notoriously difficult – remember the awfully timed OCR rate hikes in mid-2010? (At that time business lending was contracting by 8%yoy). No, I don’t have confidence in the RBNZ to time the market.

To reduce systemic risk the regulations should be about higher capital adequacy and quality of their mortgage books. Financial stability should see through the cycle and have right regulations in place to let lenders and borrowers choose how they borrow and invest – without the RBNZ changing the rules on an ad hoc basis.

It has always been clear that the aim should be to increase the resilience of the system to adverse shocks, but is it possible to be more ambitious? The traditional prudential approach has had a strong focus on shock-absorbing capacity; for example, increasing capital requirements so that banks are better able to absorb loan losses. This approach largely takes movements in credit and asset price cycles as a given, and aims to provide an adequate safety net should systemic risks be realised. A more ambitious approach is to try to reduce the amplitude of the financial cycle – in a sense lopping off the extremes of the cycle. Swing low but not too low; swing high but not too high. The potential benefits of this approach are obvious but it is also much more demanding, as it requires the authorities to answer some difficult questions.

Hmmm.  This seems to be saying that simply ensuring the resilience of the financial system is not enough, the central bank should be trying to exert direct, and discretionary, control over what financial markets do and where investment heads.  Fine tuning at its finest.  It does appear that policymakers here have been strongly influenced by Borio.

That’s me, I’m done with writing about macroprudential policy in New Zealand.  If you want to know why, read below the flap

The Bank is moving away from its mandate with actions like this.  They say that additional action beyond ensuring shock absorbing capacity in financial markets makes sense as:

a disorderly unwinding of a credit boom to impose substantial losses on the financial system, leading to an adverse feedback cycle with the real economy and substantial damage in the form of lost economic output, jobs and wealth

But the entire point there is “disorderly”.  If prudential policies are focused on ensuring that the banking system has a sufficient buffer against adverse shocks, the wind down of a credit boom is not “disorderly”.  This entire story is a red herring.

Standing against deteriorating lending standards, ensuring banks are holding sufficient equity/capital, that is accepted widely and I’m on board.  But that doesn’t mean we should be chasing around asset prices driven by a ‘credit monster’.  If there is a “bubble” when lending standards are unchanged and financial markets are not at risk, there is NO ROLE for central banks.  Central banks are not there to pick who the winners and losers of transfers are.  Central banks are not there to determine investment decisions for individuals firms and industries.  That is a central planner – the two are spelled differently.

I suppose this change in tack from the Bank makes “sense” if we think about some of the recent talk.  For some strange reason the Bank has suggested that LVR (loan-to-value mortgage) limits could be in place for years – even though real estate agents and second-tier lenders are trying to undercut the regulations before they have even begun.  If the Bank’s goal is to create a unregulated shadow banking system, then sure keep LVR limits in place for years.  They have also seemed incredibly willing to use transfer and equity/fairness arguments when it is not their role (here and here).

The level of discretion they are suggesting staggers me.  Here:

We do not see macro-prudential instruments as ‘set and forget’ tools; once deployed, there will be on-going assessments of their effectiveness, which will condition their use and their eventual release

There is a positive way to read this – namely that they are building capabilities and an understanding of the efficacy of the tools.  That is positive.  But in conjunction with their objective, this sounds like macroprudential tools based on discretion rather than rules – violating the points raised by Cochrane.

And what exactly does the Bank think this means for their future independence?  They seem to be including the price of assets, including housing into their mandate.  Furthermore, they are taking responsibility on investment going to the “right” places … eg:

instruments such as the SCR or LVR restrictions could be targeted at particular problem sectors, such as housing or agriculture, or specific borrower segments such as housing investors

If that is the way they want to communicate their new tools and their innovative thinking to the public, then I think it is fairly obvious we should start having open democratic elections for the RBNZ governor – that or just wrap it straight back into central government.

No doubt many think I’m being over the top here, but when thinking about the justification for macro-prudential policy I had firm limits on how this would fit within the mandate of an independent central bank.  And the RBNZ feels justified to go beyond that.  This is me just putting on record that they’ve overstepped what seems appropriate

Note:  When I read papers like that, I see a central bank wanting to “solve every problem” and even seeing it as their purpose.  It is not.  They are there to deal with issues which the government cannot commit itself to – namely monetary policy.  They are also supposed to be financial market regulator, which involves dealing with stability of the financial system.

However, they believe they have found a new task – helping us help ourselves, credit constraining us when we get too excited and easing that constraint when we are scared.  I do not have the faith in their knowledge of social value, nor do I think they can successfully keep credibility about monetary policy while following such a discretionary path with monetary policy consequences with other tools.  To quote Bernanke again:

In the United States, the heyday of discretionary monetary policy can be dated as beginning in the early 1960s, a period of what now appears to have been substantial over-optimism about the ability of policymakers to “fine-tune” the economy. Contrary to the expectation of that era’s economists and policymakers, however, the subsequent two decades were characterized not by an efficiently managed, smoothly running economic machine but by high and variable inflation and an unstable real economy, culminating in the deep 1981-82 recession.

To the Bank I have one question – what is your implied welfare function that involves you trying to second guess individuals choice of where to invest and what in?  Is it based on a presumption that you simply know what is good for people better than they do, has their been some actual consideration in terms of normative economics.  I bring this up primarily because, if you are going to get involved in the game of justifying direct policy interventions like a central government you need to be able to justify them in the same ways, with the same sort of CBA measurements, and with the same level of certainty.

Side note:  Since I genuinely don’t plan to post about macroprudential policy again outside of “interest links posts”, I have to note I also agree with Lars Christensen in this link:

So I remain skeptical about the usefulness of macroprudential policies – in fact I believe that an over-reliance on such policies could lead to an increase in the volatility and fragility of the global financial system rather than the opposite.

When the policies become discretionary, and the Bank focuses on micromanagement, the actual goal of stability can be compromised.