Bleg: Grimes on bubbles

Arthur Grimes recently gave an interview to Reuters, all I’ve seen so far is this write up via Raf on Twitter (cheers).  Now Grimes is an incredibly good New Zealand economist, to put things in perspective I would generally put more weight on a single line of his opinion of something than I would on my own intuition and analysis of issues – an given that as individuals we are strongly biased towards our own views that is pretty significant.

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)

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LVR speed limits are here

RBNZ restrictions on high loan to value ratio (LVR) mortgages came into effect on 1 October 2013. They are already biting – with ASB pulling its high LVR approvals. By definition, the new rules will reduce high LVR borrowing growth, but not necessarily total borrowing (because banks are now incentivised to lend ‘traditional’ mortgages). The international evidence on impact on house prices is mixed at best and the RBNZ’s regulatory impact assessment is pretty up front about it.

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.

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That’s it, I’m done: RBNZ takes the path of discretion

A paper from the latest RBNZ bulletin.

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 😉

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Bank of England on solvency and liquidity

Nice communication piece by the Bank of England by talking about solvency and liquidity:

The article explains that a bank’s capital base and its holdings of liquid assets are both important in helping a bank to withstand certain types of shocks. But, just as their natures as ‘financial resources’ differ, so does the nature of the shocks they militate against. The article addresses some misconceptions about capital and liquidity, explains the important differences between the two resources and describes where they sit on a bank’s balance sheet, using clear visual examples.

Go give it a read, it is neat.

Note:  Liquidity is about the mismatch between the length of maturity on assets and liabilities.  Solvency has a bunch of interesting issues to think about – with a strictly free market without information considerations we may not really care.  However, the lack of knowledge (namely asymmetric information in the face of liquidity mismatch) about whether a bank is truly solvent creates as issue.  We think about “solving” this with bank insurance – but this in turn changes the way banks and other financial institutions behave, and the way that risk is treated by depositors, lenders, and financial institutions as a foil between them.  This is where we come in talking about moral hazard!

Note to note:  By calling financial institutions a foil, I am not claiming anything like “deposits make loans” or “loans make deposits” – that would be a red herring.  The simple fact is assets and liabilities have to meet – and banks set assets and liabilities based upon expected risk and rates of return given the institutional and regulatory structure.

Cochrane’s macroprudential rules

John Cochrane has a great post up on his blog about macroprudential policy, where he notes three important rules to their implementation:

  1. Humility about our lack of knowledge, and thereby avoiding fine-tuning (note, the burden of proof may be set in different ways for “structural” policy – but when it comes to changing policy actively this constraint needs to be admitted).
  2. Follow rules where possible instead of relying on discretion.
  3. Limited power to “manage” the economy is part of independence – the more the Fed/central banks take on the more their independence will be undermined.

I agree with these rules, and think I was consistent with them in my recent discussion on LVRs in New Zealand here and here.  I believe that central bank policy over here in New Zealand takes these issues into account – but I also have no doubt there is a clear debate to be had around rule following vs discretion (as has been had with inflation targeting).  As a result, I will try to keep my mind open with regards to new information and new arguments 🙂

Update:  Lars Christensen discusses the article in a lot more detail – strongly recommended read!

LVRs are coming: Let’s think about the causes underlying this

I see the RBNZ has come out with the details of the LVR restrictions (loan-to-value limits on mortgages) they may well put in place soon.  That is cool.  I’m also a big fan of the “question and answer” style discussion of people’s submissions here.  Brennan McDonald summarises the details here.

However, in the release about this, there were several quotes about LVRs that I had to admit I had issues interpreting.  Either these quotes miscommunicate the justification the Bank is using for such policies, I have completely misinterpreted the quotes, or they communicate it perfectly and I fundamentally disagree with the association they are using.  These ones are not about housing affordability, they seem to strike at something more fundamental.

As a result, I thought I should have a chat about the quotes in question – and why I think our understanding of them, and the causal mechanisms involved, is central to thinking about policy.

The quotes are:

“LVR restrictions on residential mortgage lending can help to dampen excessive house price growth in periods when credit growth is boosting housing demand beyond housing supply,” Mr Spencer said.  “In so doing, they can reduce the risk of a rapid correction in house prices and the economic and financial instability that would ensue.

“In situations where house prices are overvalued, the further that house prices rise, the more likely it is that a disruptive downward correction will occur.  Such a correction would be very damaging if combined with a significant deterioration in economic or financial conditions.”

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