By Joseph E. Gagnon
In his speech at the American Economic Association yesterday, Ben Bernanke said that monetary policy played at most a small role in the U.S. housing bubble and that financial regulatory policy is the appropriate tool for preventing harmful asset price bubbles in the future. I agree with these conclusions, but I suspect that many do not, even within the world of central banking.
Brad DeLong recently described the dilemma about bubbles that some central bankers may believe they face. On his weblog, DeLong presents a simple model of a bubble caused by a central bank that holds the short-term interest rate below its long-run equilibrium in order to offset a shortfall in aggregate demand, i.e., to fight a recession. This bubble is caused by the “carry trade.” Speculators borrow at the low short-term interest rate to purchase a long-term asset at a price above its long-run expected value. They know that the asset price will fall when the central bank raises the interest rate at some future date, but in the meantime they can earn income above their cost of borrowing (this excess income is known as the “carry”).
If speculators correctly evaluate these costs and benefits, their expected carry will equal the expected fall in the asset price and there is in fact no bubble. Another way of saying the same thing from the point of view of an unleveraged investor is that the expected returns to holding either the high-priced long-term asset or a short-term deposit or T-bill are the same. Indeed, by lowering the short-term interest rate, the central bank intentionally raises the fundamental value of the long-term asset in order to stimulate private spending.
However, if speculators incorrectly assume that they are smart enough to sell before the price of the long-term asset falls, or if they believe that the government may bail them out when the asset price falls, then there will be a bubble — the asset price will rise too high. DeLong assumes that the bursting bubble causes a decline in social welfare equal to any bailout plus an amount proportional to the squared losses of the speculators.
DeLong’s model cleverly captures many key features of an asset bubble and yet remains simple enough to draw clear conclusions. He shows that overconfidence about being able to get out before the bubble bursts and expectations of a bailout make bubbles costly. The cost of bursting bubbles discourages the central bank from lowering the interest rate as much as it needs to stabilize the economy. These results reflect the dilemma that many observers currently see in monetary policy–how to walk the fine line between easing too little to fight unemployment and easing too much to cause a new and harmful bubble.
The main drawback of DeLong’s model is that it overstates the welfare costs of bursting bubbles in two ways. First, it assumes that all declines in long-term asset prices are costly even if they are not associated with bubble-like behavior. Second, it ignores the role of unleveraged or partially leveraged investors. Modifying his model to correct these shortcomings leads to a very different conclusion for economic policy.
Bursting bubbles are economically harmful only to the extent that they bankrupt investors or raise fears that investors will go bankrupt. Bankruptcy imposes deadweight losses on society, resulting from the resolution process and the delays and uncertainty associated with it. Fear of a counterparty’s bankruptcy causes financial markets to freeze, disrupting overall economic activity. Lenders also appear to alternately underestimate and overestimate potential default losses and these swings undoubtedly are costly.
In DeLong’s model, the welfare cost of a bursting bubble is related to the square of the losses faced by investors. 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.
The way to reduce the cost of a bursting bubble is to reduce leverage. 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. For example, the technology bubble of 2000 burst with no apparent ill effects because it was not leveraged to any significant extent and there were no government bailouts. The recession of 2001 was very mild and probably was unavoidable given that GDP was above potential in 2000 and inflation was rising.
As I have argued elsewhere, monetary policy actions to support and even increase the prices of long-term assets are warranted now to speed economic recovery and avoid deflation. Excessive increases in the prices of houses and equities are not likely given the recent experience of investors with losses in both of these markets. The old adage–once bitten, twice shy–is probably in effect for some years to come. Moreover, real estate lenders are demanding much higher down payments with stricter standards for appraisals than in the past, greatly reducing opportunities for leverage in the property markets.
Some observers, including Jim Hamilton, are concerned that low interest rates are pushing up commodity prices, possibly creating a new bubble. It is important to recognize that the susceptibility of commodities to bubbles is directly related to their storability. That is why it is easy to have a bubble in gold and impossible to have a bubble in lettuce. Storage capacity for the most important commodity — petroleum — is a relatively small fraction of global consumption, which limits the size and duration of any bubble in its price. (Indeed, the rise and fall of oil prices in 2008 appears to have reflected a bubble, but one that lasted only a few months.) Commodity prices also are sensitive to the state of global economic activity, making it difficult to determine whether or not rising commodity prices at a time of global economic recovery are excessive. In any case, the key is to avoid leveraged investing in commodities.
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. See, for example, the Geneva Report on “The Future of Financial Regulation” and the Pew Task Force statement of “Principles on Financial Reform.” Focusing on the housing market, my colleague Adam Posen also has proposed linking property-related taxes to property prices in order to damp their swings.
The bottom line is that 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.
This post written by Joe Gagnon