Monday, July 13, 2009

Central banks, housing, and asset bubbles

I am reading a great book by George Cooper, "The Origin of Financial Crises", which describes in detail his theses regarding central banks and their inherent reliance on the efficient market hypothesis. He criticizes central bank policy for being too lax as the economy heats up, and only aggressive as the economy enters recession. I haven't finished the book yet, but I believe that general conclusion will be that the Fed should use its powers to target asset price bubbles to offset the failure of the efficient market hypothesis and irrational investor behavior. Interesting.

In the book, he gives an example of the problem faced by central bankers reacting to "irrational" investor behavior. The following is an excerpt from a speech made by Jean Claude Trichet at the Mas Lecture in Singapore on June 8, 2005, "Asset price bubbles and monetary policy":
There is no consensus about the existence of asset price bubbles in the economics profession. Well reputed economists claim that even the most famous historical bubbles – e.g. the Dutch Tulip Mania from 1634 to 1637, the French Mississippi Bubble in 1719-20, the South Sea Bubble in the United Kingdom in 1720 as well as the worldwide new economy boom in the 1990s[2] – can be explained by fundamentally justified expectations about future returns on the respective underlying assets (or tulip bulbs). Thus, according to some authors, the observed price developments during the episodes that I have just mentioned – although exhibiting extremely large cycles – should not be classified as being excessive or irrational. For example, with regard to the new economy boom of the late 1990s it has been argued that uncertainty about future earnings prospects increases the share value of a company, especially in times of low risk premia.[3] This claim can be derived in a standard stock valuation model, where the price-dividend ratio is a convex function of the mean dividend growth rate. The mean dividend growth rate in turn depends obviously on future expected earnings of the company. Heightened uncertainty about future earnings will increase the price-dividend ratio. It has further been claimed that assuming apparently reasonable parameter values with regard to the discount rate, expected earnings growth and most importantly the variance of expected earnings growth, one can reproduce the NASDAQ valuation of the late 1990s and its volatility. There would thus be no reason to refer to a dotcom bubble. I do not mention this example because I believe the NASDAQ valuation of the late 1990s was not excessive. However, if one takes the narrow definition of a bubble very often used by these economic researchers,[4] there is a fundamental difficulty in calling an observed asset price boom a bubble: it must be proved that given the information available at the time of the boom, investors processed this information irrationally.
In order to target asset bubbles using monetary policy, one must be able to prove that the market participants were no way the wiser, given market information at the time, and acting irrationally. To me, this is exactly why targeting asset prices is difficult for the Federal Reserve, whose mandate is to promote a healthy economy through maximum sustainable employment, stable prices, and moderate long-term interest rates.

When targeting asset prices, the Fed must know that the underlying economic fundamentals have changed. All else equal, maximum sustainable employment and stable prices are no longer possible. One runs into the quintessential problem with macroeconomic data: heavy revisions.

A paper by James Kahn at the Federal Reserve Bank of New York argues that the housing market is not an asset bubble, i.e., households and market participants acted rationally rather than irrationally. Households and bankers could not have known that productivity growth had markedly slowed toward its trend in the 2004-2007 years, and taking with it, expected income levels. Here is an excerpt from the conclusion (although the short read is worth a look):
Housing market participants were slow to perceive the most recent decline in the rate of productivity growth because the data released through mid-2007 gave little indication of it. Subsequent revisions of the data made it clear that productivity had in fact begun to decelerate in 2004. Nevertheless, given the information available through much of the current decade, borrowers and lenders might reasonably have inferred that productivity growth remained strong—an inference that would encourage optimism about income prospects and hence higher expenditures on housing.

These findings, together with the previous discussion of the relationship between productivity growth, income, and housing prices, suggest the following scenario for the most recent housing cycle: With the resurgence in productivity that began in 1995, market participants began to see stronger income growth—not from working longer hours or having a second household income, but on a per hour basis. As individuals became more aware that this stronger growth was attributable to technological progress and that it might be sustainable, they grew more optimistic about their future income, and this optimism directly infl uenced their willingness to pay for housing. Such optimism would likely have been shared by lenders, who viewed mortgages as less risky insofar as income and house prices were growing more rapidly than before.

A decade later, however, signs emerged that the new period of high productivity growth would not be as long-lived as the post– World War II episode, which had lasted more than twenty-five years. As buyers and lenders began to recognize this, the same process that caused prices to rise and credit conditions to ease began to work in reverse. The expected income growth did not materialize and new buyers entering the market were less willing to pay high prices; thus, prices of houses purchased in recent years failed to grow as expected. Foreclosures began to increase as early as 2005, and lenders became more cautious.
Basically, household expected income had changed without the knowledge of the household. Therefore, it could be argued that there was no economic fundamental basis for which the central bank would have known that an asset bubble was forming. To be sure, lending standards and underwriting methods should have been regulated. The Fed could not have known that households would later be deemed irrational, and that economic fundamentals had slipped out from under the economy until well after the bubble formed due to heavy revisions in the data.

Interesting stuff. Here is what Bernanke said in a similarly titled speech to Trichet's, "Asset-Price "Bubbles" and Monetary Policy" on October 15, 2002:
So the problem of a bubble popping Fed is much tougher than just deciding whether or not a bubble exists; to follow this strategy, the Fed must also assess the portion of the increase in asset prices that is justified by fundamentals and the part that is not. In my view, somehow preventing the boom in stock prices between 1995 and 2000, if it could have been done, would have throttled a great deal of technological progress and sustainable growth in productivity and output.
It seems pretty clear, that it would take a rather robust methodology to change the Federal Reserve Act in order to mandate the targeting of asset prices. But who knows. It does seem hard to argue that homebuilding, hence real economic activity, was not bubble-ish. Starts remained around the 2 million mark between 2003-2006, while the Fed's incremental rate hikes did not commence until June 2004 (from 1%).

Rebecca Wilder


  1. Rebecca

    Another post with great insight! The most notable comment is your last paragraph regarding Housing Starts.

    A review of the data for 2003 to 2006 indicates that approximately 4 million excess housing units were built and the graph does present this clearly.

    My question is how difficult would it be to generate the graph with the assumption that housing starts tracked natural population growth (say 1 to 1.2 million units per year were built). I believe that such a graph would demonstrate that the housing bubble could have been avoided with more direct attention on known data. Ignoring data for four years is always going to be a recipe for disaster.

    The purpose of my question focuses on the commentary of proactive vs. reactive response. My observation is that proactive steps could have been taken to increase interest rates and slow the housing construction boom. An easy Monday Night quarterback comment to make, but I have been tracking this issue since 2004 and kept asking the same question over and over: Why are so many houses being built when the population growth does not support it. (see real estate reports Housing In Crisis.

    We need to learn from this to avoid the situation in the future, but I thought the same thing in the early 90’s and look what happened.

    John Watch

  2. Like your response, John! Why is it that there were traders, dealers, etc. out there saying get out of equities back in 2005/6? There was a definite feeling of being out of control that is not quantitative but can be just as real. Sometimes I think we need to listen to our gut feelings as well as read data. The bad lending practices had much to do with the problem, too.

  3. vacuous, in the G.6 all debits cleared thru demand deposits (with the exception of mutual savings banks). bank debits included property transactions, stock transactions, etc.

    economic lags for real-growth and inflation are always fixed. only their rates of change vary. forecasts as such, are infallable.

  4. Hi John Watch,

    Thanks for commenting, and thank you for the link!

    You say, "My question is how difficult would it be to generate the graph with the assumption that housing starts tracked natural population growth (say 1 to 1.2 million units per year were built)."

    I agree, popoulation growth (better, household formation) would probably serve as a good proxy for trend construction.

    I have seen estimates that say 1.3-1.7million starts are needed to sustain household formation. Starts were growing at a 2 million + annualized rate for a couple of years - there is A LOT of overhang to work off.

    You are right - even if the Fed didn't feel that it could target asset prices with any efficiency, it surely could have regulated better the mortgage, underwriting, and securitized asset industries!

    Thanks for commenting

    Hi Aunt Jane,

    I think that listening to your gut goes the other way, too. On the way up, too many individuals stretch b/c their gut tells them that prices will continue to rise...this is definitely irrational.

    It's so good to hear from you. How is Jackie? Phoenix?


  5. HOT is the operative word - Bonsall is much better - phenominal last weekend aj


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