Visit http://indiaer.blogspot.com/ for complete details Little has changed: easy money still risks
blowing asset bubbles across the region
Impending monetary loosening in the US
will only aggravate Asia’s policy dilemma
We explore the evolution of bubbles with
insights from behavioural economics
Here we go again
Regular readers will recall our series on the anatomy of asset
bubbles last year, warning of the risk of loose monetary and
financial conditions. This call remains well on track. We thus
thought it would be worthwhile to issue an updated version of
the series, drawing renewed attention to Asia’s policy dilemma.
Asset bubbles are curious animals. They evolve in stages,
rather than in a straight line. Excessive caution usually breeds
policy inaction with ultimately fatal consequences. A better
understanding of their evolution is essential for investors and
officials alike to avoid the pitfalls strewn across their path.
Averting asset bubbles is easier said than done. No doubt. As
we noted elsewhere (see The options: what can Asia do about
bubbles?), the region faces a tough set of policy challenges.
The options include appreciation, rate hikes, capital controls,
tighter financial regulation and fiscal consolidation. No single
measure will prove sufficient. Only a mix will do. This raises
policy risks. The next few months, therefore, could be rather
volatile: the West eases and the East needs to respond. Decisive
action is needed. Whether it is coming is by no means clear.
Chapter one looks at the initial conditions required for the
occurrence of asset bubbles. Uncertainty is needed to keep
policy-makers forgiving, even as investors ready the lotion
and jump in the pool. Chapter two deals with what’s needed
to sustain the run. Leverage is essential, and rising asset values
render marginal tightening ineffective. Chapter three closes
in on the end, when a powerful narrative justifies dizzying
valuations, and even the most hawkish policy-makers can
get carried away with the frenzy before the show unravels.
We pay particular attention to psychological findings and
what new behavioural insights teach us. If you think it’s still
about strict rationality, we suggest you open a newspaper
every once in a while.
We just don’t know
In the beginning there is uncertainty. Economic
prospects at this stage are extremely difficult to
judge and risks are deemed to be extraordinary in
an historical context. This, then, elicits a
prolonged period of policy accommodation: rates
are kept low, or extra cash may even be injected
into the economy, to guard against tail-risks of
economic calamity. It is difficult to appreciate in
hindsight the uncertainties that are involved in
policy decisions at any one point in time. But, the
future, as our readers well know, remains
impossible to predict. One is left, therefore, only
with the certainty of contemporary facts, which at
this stage draw a dark, discouraging picture of
possible economic abyss.
Only think of the US housing bubble. It is now
commonplace to suggest that one of the main
contributing factors was an extended period of
low interest rates between about 2001 and 2004.
Other factors, of course, mattered as well, such as
the inflow of foreign savings and new financial
instruments; but monetary accommodation in the
run-up to the bubble played a central role. Why
were interest rates not raised earlier?
Wind back the clock for a moment. In the aftermath
of the tech bust, concerns in the US centred on the
risks of deflation. After the dreadful experience that
Japan had just suffered through, and with various
price gauges plunging to unaccustomed depth,
monetary officials worried that the United States
might slip into a similar trap where prices would
fall and turn the tech rout into a decade-long slog.
To top things off, a dramatic terrorist attack kept
everyone on edge, as did a subsequent war in Iraq.
At the time, it hardly seemed justified to raise
interest rates to prevent a housing bubble that
could conceivably develop years down the road.
They aren’t alike
All pretty straight-forward. But one puzzle remains:
if uncertainties are such that policy-makers will
not tighten monetary policy, why would investors
venture out and start to buy assets, kicking off an
asset price spiral that years later ends up in a fullblown
bubble? After all, the same information is
available to all. If investors are brave enough to
jump into the pool in spite of lingering uncertainties,
officials should act as well and put an early stop
to the incipient party.
A sustained rally, or a bubble, requires a marginal
buyer of assets. Funds for such purchases have
only two sources: profits and leverage. In general,
the former is associated with sustained rallies,
while the latter is more commonly found in asset
bubbles. Over the coming years, the outlook for
profits remains a little challenging as excess capacity
and rising raw material costs squeeze margins. So
leverage remains the main source of cash for
marginal asset purchases. Asia is among the few
regions in the world able to lever up. That’s why
bubbles are more likely to occur here.
The bigger picture
We are all a little too caught up in the daily grind
of financial markets. It helps to take a step back
every once in a while. What drives asset prices
over time is not so much the relative performance
of a company or sector, or the relative preference
of investors for bonds and stocks. These things
matter, of course. But in the long-run any run-up
in asset prices can only be sustained if extra cash
is being generated for their marginal purchase.
Broadly speaking, there are only two sources for
such funds. The first arises if past economic
investments yield healthy returns. The resulting
profits, then, generate the cash that can be used
for asset purchases. What’s more is that the robust
returns on such investment, as long as they prove
sustained, justify rising asset prices. The second
source is financial leverage whereby the financial
system generates extra cash that ends up fuelling
the demand for assets. Note that financial leverage
can occur when underlying profits are not rising,
although investors certainly expect profits, whether
speculative or economic, to increase in the future.
Of interest here are only rallies sustained over the
course of a few years, not the short-term gyrations
that financial markets are prone to. Take the
stunning rebound since the lows markets reached
in March of last year. The move has surely been
impressive. But, arguably, it doesn’t include the
ingredients of a sustained rally. For one, there has
been no jump in structural profits in the economy:
cyclically, of course, profits have begun to recover,
but this reflects merely normalization after an
unusually deep slump. In addition, with the notable
exception of China, there has been no real rise in
leverage. Rather, the Western financial system is
still de-leveraging, a process that will continue for
quite some time.
Once an asset bubble gets under way, it becomes
exceedingly difficult to stop. Conventional
monetary policy is swiftly overwhelmed by the
momentum of an asset price spiral, and marginal
rate increases lack the potency to stop the train in
its tracks. This highlights the need for pre-emptive
rate hikes in order to prevent a bubble from
forming in the first place. But policy-makers fear
losses more than gains in the early stages and
remain accommodative. Once the bubble matures,
euphoria grips officials as well, enabling them to
buy into the rationalization for the dizzying rise in
asset prices. Until the bubble pops.
Hitting the accelerator
One of the curious aspects of an asset bubble is
that it is immune to marginal interest rate increases.
Consider, again, the recent experience in the US:
once economic uncertainties and perceived risks
of deflation dissipated in 2004, the Federal Reserve
embarked on a series of interest rate hikes. Yet,
monetary tightening had no influence on the
housing market. Rather, the hot phase of the
property rally was between 2004 and 2006,
precisely the time when the Fed tightened the
screws. This is quite a common feature of bubbles:
asset price increases and interest rate hikes can
coexist for quite some time, with seemingly no
effect of the latter on the former.
What is the explanation for such impotency of
monetary policy? Two answers. First, consider the
notion of the financial accelerator. This essentially
states that rising asset prices boost the value of
collateral for loans. In turn, banks become more
willing to lend, loosening lending criteria and terms.
An initial cut in interest rates, therefore, carries
through over time via rising asset prices that
effectively prolong the impact of monetary easing.
This effect may eclipse the rise in interest rates so
that financial conditions – as opposed to monetary
conditions – become progressively looser and not
tighter, further fuelling asset price gains. The
financial accelerator, in short, reduces the potency of
rate hikes once an asset rally is under way.
The fact that banks loosen their lending criteria
during a run-up in asset prices is partly a behavioural
phenomenon. Bankers, along with everyone else,
are eventually infected by general euphoria about
prospects for growth and the consequent justification
for rising asset values. But, this is not an
instantaneous reaction to any rally. It takes time
for loan officers and risk managers to react to
developments in asset markets. In any decision,
proximate experiences feature far more prominently
than more distant events. Initially, therefore, risk
aversion prevails following a bust. The longer the
rally endures, however, the more prevalent becomes
the impression of rising asset prices and lending
conditions are subsequently eased.
These insights hold immediate relevance for us
today. Despite the debate about the timing of exit
strategies of central banks, it is far from certain
that a gradual tightening of monetary conditions
over the coming quarters would have a similar
impact on financial conditions and therefore
curtail the appreciation of asset prices. Following
the recent bust, lending criteria, even in Asia,
remain tight and are only now showing signs of
being gradually relaxed. Even the most hawkish
advocates of rate increases hardly expect a big
jump in policy rates by late 2011. Gradual rate
hikes, therefore, may well be offset by a loosening
of lending criteria among commercial banks.
Of course, there are notable differences among
countries. In China, if anything, lending criteria
may be tightened after being extremely loose over
the past two years, although even here rising asset
prices may offset some of the intended tightening
effect. Elsewhere in Asia, the run-up in asset
prices is likely to serve as a more powerful
financial accelerator: bank lending guidelines are
less controlled by policy-makers and because
commercial banks had tightened criteria more
during the crisis than in China, they still have
some way to go towards normalization. In the
West, meanwhile, lending criteria may be relaxed
more gradually than in Asia, reducing any
immediate risk of an asset bubble. Moreover, even
if bank officers are starting to ease conditions in
these countries, the disappearance of the shadow
banking system will weigh on the overall availability
of credit for years to come.
Getting used to it
Apart from the financial accelerator, there is a
second reason why the potency of rate hikes can
be surprisingly limited. Once again, consider the
US housing bubble. The Federal Reserve, as
mentioned, raised interest rates considerably
between 2004 and 2006. However, long-term
interest rates did not rise in accordance, something
termed a “conundrum” at the time. This, in effect,
allowed the housing bubble to flourish despite
hikes in the Fed Funds rate. One explanation
frequently put forward was that inflows of foreign
savings, especially by Asian central banks with a
penchant for secure long-term investments, pushed
down benchmark rates along the yield curve.
There may be something to this explanation,
although we wouldn’t push that argument too far
since it is not clear that there was indeed a global
glut of savings as many had argued at the time.
Rather, our argument concerns market psychology
and the strategy for US rate hikes. The Federal
Reserve raised interest rates at 25bp increments
over a period of more than two years. This was a
fairly predictable and consistent pattern of
monetary tightening, justified in part by the
prevalent belief among central bankers that
monetary policy needs to be as transparent and
unsurprising as possible to allow the market to
properly price risk. The trouble with this
approach, however, is that it engenders something
termed “habituation” among investors: consistent
and predictable policy rate hikes lose their
potency because they are anticipated by the
market, pushing down the risk premium on longterm
bonds even as the policy rate rises.
Currently, with uncertainties over the future path
of growth extraordinarily large, and central
bankers still wedded to the concept of the need for
predictability and transparency in monetary
policy, we fear that officials will repeat the
mistake of the past, which was to tighten too
gradually and predictably. This, in turn, may once
more lead to habituation among investors, who
will come to shrug off any rate hikes as essentially
inconsequential for their investment prospects.
What would be needed, in fact, is for central banks
to inject a degree of “deliberate uncertainty” into
financial markets in order to avoid habituation and
thus raise the potency of any rate hikes. Such
uncertainty may be generated by raising rates
more than the market anticipates at any particular
policy-meeting, thus preserving a certain level of
policy risk premium in the pricing of securities.
How likely is it that central banks will follow these
insights from the behavioural school? We doubt
officials will adopt strategies of injecting deliberate
uncertainty into financial markets. In the West, a
number of central banks have already committed
themselves to keeping interest rates low and stable
for a long time, implying rate hikes will materialize
only gradually and likely in a predictable manner.
In Asia, central banks have in the past acted a little
less predictably. Only this week, officials in China
hiked rates to everyone’s surprise. In Korea and
Taiwan, too, the authorities are prone to throwing
the occasional curve-ball at the market. But, in a
region of general asset price appreciation over the
coming years, and given the scale of the
dislocation of monetary conditions, even this may
not be sufficient to inject the necessary policy
uncertainty to prevent bubbles from growing.
One possibility, however, is that policy-makers use
surprise regulatory tightening to shake things up.
As we noted elsewhere (see The options), Asia is
facing a number of policy constraints currently,
making it necessary to resort to a mix of different
measures to prevent asset bubbles, including fiscal
consolidation, capital controls, exchange rate
appreciation, and financial regulation. The variety
of measures, and in many cases their untested
nature, certainly raises investor risk and may lead
to surprise policy announcements over the coming
months. But, whether this is enough to redress the
structural imbalance in world monetary condition
requirements (Western easing, Eastern tightening)
remains to be seen.
Caught in the act
Once bubbles are in full swing, central banks
evidently need to tighten aggressively and
surprisingly in order to derail asset price momentum.
But, over the latter stages of such rallies, policymakers
tend to remain comparatively inactive as
well. There is a behavioural reason for this. The
supporting narrative for the rally eventually acquires
some plausibility among everyone involved,
including officials. Especially in emerging markets,
rising asset prices are often taken as a sign of
economic success. Given that policy-makers in these
economies are usually more intimately involved with
guiding the economy than in advanced markets,
there is a tendency to interpret a rise in asset prices
as corroborating the expediency of public policy,
rather than being a folly of the market. This is, in
fact, quite human: decision-makers are prone to
interpreting available information as
substantiating their prior actions.
With economic policy thus remaining
accommodative, asset prices continue to rise,
usually at an ever-accelerating pace, until the final
collapse arrives. While it is tempting to think that
public policy usually puts a stop to bubbles, this is
in fact incorrect: most such rallies tend to fizzle out
on their own, mostly because the cumulative
misallocation of capital over the course of the
investment boom starts to generate losses that
gnaw at the confidence of investors. With falling
profits and declining leverage, the marginal buyer
of assets, so crucial to sustain the run, eventually
disappears. The collapse, then, comes hard and fast.
And policy-makers are tasked to clean up the mess.
Our world, now
In the first three chapters we outlined the different
stages of asset bubbles, paying particular attention
to new insights from behavioural economics. In the
first stage, unusual economic uncertainty leaves
policy-makers biased for accommodation, fearing
a relapse into recession more than investors do.
Markets, in this phase, rally as idle cash is deployed
from the sidelines, leading to a quick rebound from
the panic sell-off that gripped the market during
the earlier bust. A cash rally, however, only carries
so far and for the run-up to be sustained either
profits need to rise or leverage has to build.
As valuations approach bubble territory, a
powerful narrative emerges that justifies higher
asset prices still. Eventually, these help to lift
growth and dispel residual uncertainties about
economic prospects. At this stage, policy-makers
begin to tighten monetary policy. But, marginal
rate hikes often have little impact, being eclipsed
by the rise in collateral value, which loosens
financial conditions further. As the bubble matures,
a more aggressive monetary policy response is
called for but not forthcoming: officials themselves
start to be caught up in the narrative, in part
because the alleged economic gains reflect positively
on the conduct of public policy. As losses mount,
the run in assets eventually turns into a rout.
How likely is an asset bubble in Asia over the
coming few years? Quite. Although hardly
inevitable. Already, markets have rebounded
sharply as idle cash was rapidly deployed. A
breather may eventually be necessary to sustain
the run in asset prices, given that a consolidation
would allow policy-makers to remain
accommodative and other investors to buy into the
market. Economic uncertainties are likely to remain
such that officials are not in a position to tighten
monetary policy aggressively any time soon.
Moreover, even if profits may not materialize, the
region’s financial systems remain capable of
generating substantial further leverage to power a
sustained run in asset prices.
Lastly, there is palpable optimism that the region
will indeed be the “next big thing” on the global
economic agenda. The key, therefore, is whether
policy-makers will eventually step up to the task
and spoil the party. History suggests that this is
extremely difficult to do and the current mindset
among the region’s central bankers makes
decisive action arguably less likely. Not every
recession, of course, sets the stage for an asset
bubble, but, as things stand currently, this looks
like one of those times.
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