July 23, 2016

A Fundamentally Flawed System

A weekend topic on the housing bubble and policy starting with the Evening Standard. “It is generally a mistake to assume that because someone is in charge, they know what they are doing. It is not just politicians we should worry about, however. The same can be said of technocrats, many of whom wield as much power. This list comprises many business leaders but, most of all in today’s world, it also includes central bankers. For the past eight years, we have by and large assumed these figures of authority knew what they were doing, even when they pursued ever more extreme and experimental policies — always with the best of intentions, but with no real idea of how they might pan out.”

“In a speech earlier this month, Hans Hoogervorst, the one-time Dutch politician who now chairs the International Accounting Standards Board, drew attention to the reservations expressed by Jaime Caruana, general manager of the Bank for International Settlements — the central bankers’ club. Caruana said with refreshing honesty: ‘At this stage, we don’t fully understand the implications of low or even negative interest rates for the financial system and the economy as a whole.’”

“Clearly, central bankers operate to different rules. It is not as if we do not know some of the negative side-effects of ultra-low interest rates, which are at the core of current unconventional monetary policies. Hoogervorst even quotes the 82nd BIS annual report, which talks about how low rates increase leverage in the system. The 2008 blow-up was a classic credit crisis caused by the excessive build-up of debt in the economy. But thanks to low interest rates, leverage today is now even higher than it was then.”

“McKinsey has done the sums. In 2007, the combined worldwide debt of households, governments, corporations and the financial sector was an astonishing 269% of global GDP. By the end of 2014, it was an even more astonishing 286%. Add in the unfunded pension liabilities of various governments round the world, which Citigroup estimated in March to be $78 trillion (£59 trillion) for the 20 leading OECD economies, and the overall indebtedness of the world’s economy today comes to more than 400% of global GDP.”

“As Hoogervorst says, it is hard to see how this is going to end well or how these obligations can be met in an orderly fashion. There is a social cost, too. Unconventional policies such as quantitative easing fuel asset-price inflation in stock markets and property. This contains the seeds of future instability and, with expensive housing in particular, can have huge negative consequences for society, accentuating inequality and intergenerational unfairness. London housing is now 50% higher than it was before the 2008 crash.”

“‘To be in bubble territory again so soon after one of the worst credit crunches in history defies common sense,’ Hoogervorst says.”

From Bloomberg. “Americans are about as wealthy as they’ve ever been—and that’s a worry? Yup, say veteran economists Daniel Thornton and Joe Carson. They’re concerned that the swelling of wealth could prove unsustainable because it’s far outstripped the growth of the economy since the recession’s end in 2009. Thornton, who spent 33 years at the Federal Reserve Bank of St. Louis before retiring in 2014, says in effect that we’ve seen this picture before. Household net worth ballooned in the late 1990’s and the early 2000’s; in the first instance pumped up by rising stock prices, in the second by expanding home values. Both cases ended badly, with the economy falling into recession after the bubbles burst.”

“The same thing could happen again, if you ask Thornton, who now heads a consulting company in Valley Park, Missouri. Just as occurred in the previous two episodes, the latest expansion of wealth has been driven more by rising prices of assets—in this case both shares and homes—than by improved economic fundamentals, he said.”

“The problem, Carson said, is that ‘the financial cycle is way ahead of the economic cycle.’ That’s a worry given that the past two downturns were driven by asset-price deflation. ‘Nobody knows what’s going to happen,’ Thornton said. ‘But there’s plenty of reason to think that’s a scary graph.’”

From CNBC. “Corporate debt is projected to swell over the next several years, thanks to cheap money from global central banks, according to a report that warns of a potential crisis from all that new, borrowed cash floating around. By 2020, business debt likely will climb to $75 trillion from its current $51 trillion level, according to S&P Global Ratings. Under normal conditions, that wouldn’t be a major problem so long as credit quality stays high, interest rates and inflation remain low, and there are economic growth persists.”

“However, the alternative is less pleasant should those conditions not persist. In that case, a ‘Crexit,’ or withdrawal by lenders from the credit markets, could occur and lead to a sudden tightening of conditions that could trigger another financial scare. ‘A worst-case scenario would be a series of major negative surprises sparking a crisis of confidence around the globe,’ S&P said in the report. ‘These unforeseen events could quickly destabilize the market, pushing investors and lenders to exit riskier positions (’Crexit’ scenario). If mishandled, this could result in credit growth collapsing as it did during the global financial crisis.’”

“In fact, S&P considers a correction in the credit markets to be ‘inevitable.’ The only question is degree. ‘Central banks remain in thrall to the idea that credit-fueled growth is healthy for the global economy,’ S&P said. ‘In fact, our research highlights that monetary policy easing has thus far contributed to increased financial risk, with the growth of corporate borrowing far outpacing that of the global economy.’”

From Stefan Gerlach, Chief Economist at BSI Bank in Zurich and Former Deputy Governor of the Central Bank of Ireland. He has also served as Executive Director and Chief Economist of the Hong Kong Monetary Authority and as Secretary to the Committee on the Global Financial System at the BIS. “After having endured the collapse of its housing market less than a decade ago, Ireland has lately been experiencing a blistering recovery in prices, which already have risen in Dublin by some 50% from the trough in 2010. Is Ireland setting itself up for another devastating crash?”

“Housing bubbles are not difficult to spot; on the contrary, they typically make headlines long before they pop. Yet they are far from rare. Bubbles in Ireland, Spain, the United Kingdom, and the United States collapsed after the financial crisis that erupted in 2008. After the Asian financial crisis erupted in 1997, property prices in Hong Kong, Indonesia, Malaysia, Philippines, South Korea, and Thailand sank by 20-60%. And a decade earlier, Sweden, Norway, and Finland experienced property-price declines of 30-50%.”

“The obvious question is why nobody stepped in before it was too late. The answer is simple: while the bubbles are inflating, many people benefit. With the construction sector thriving, unemployment falling, and banks lending freely, people are happy – and politicians like it that way.”

“Because bubbles tend to inflate gradually over a number of years before their abrupt collapse, letting them run a little further seems politically astute. No one wants to be the one to stop the party – especially if their job is at stake. But the partygoers of the private sector cannot be counted on to stop themselves. In particular, banks, for which maintaining market share is crucial, cannot be expected to constrain risky lending, especially given the expectation that, if things do go wrong, the taxpayers will fund a bailout.”

“This leaves only the financial regulator or the central bank, which can use macroprudential tools – such as loan-to-value and debt-to-income ratios on new mortgage lending – to limit the deterioration of banks’ balance sheets during boom times. But this approach isn’t perfect, either, because the risky borrowers to whom lending is restricted tend to be first-time or low-income buyers.”

“By limiting the riskiest borrowers’ access to finance, rules on mortgage lending can trigger a fierce political backlash. Ireland is a case in point. In January 2015, the central bank sought to protect financial institutions from another catastrophic bubble by restricting their lending to high-risk borrowers. As a result, annual growth in property prices fell from a little over 20% to just below 5%. But the construction industry, worried about its profits, has been harshly critical of the rules, as have ordinary people who have been denied credit, and thus must struggle to find suitable housing in a small rental market. Politicians, no surprise, have jumped on the bandwagon, to capitalize on the popular mood.”

“As the pressure on Irish regulators to relax lending rules intensifies, so do concerns that they will succumb to it. One hopes that they will continue to resist. Would-be borrowers do indeed face genuine challenges as a result of these regulations; but that is nothing compared to the pain that a collapsing bubble would cause.”

“In any case, Ireland’s experience with housing bubbles carries a deeper lesson – one that virtually everyone has missed. A housing system that can so easily produce such large and damaging bubbles is fundamentally flawed. While restrictions on lending may be useful, they are not enough to bring about an efficient and stable housing system.”

“Many in Ireland might find that conclusion overly pessimistic. Maybe they are simply hoping that, this time, the luck of the Irish will hold. Perhaps it will, and this time really is different. But there isn’t much evidence of that.”

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