Policies to help the battle against the bubble

Policies to help the battle against the bubble

Quantitative easing is all well and good to help the financial system, but how do we avoid spending our way into another economic crisis?

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There’s concern that financial markets have become dependent on quantitative easing which could lead to a bubble.
Photo: Reuters

Last week, I argued against any premature interest rate rises by central banks. A couple of objections to extremely low interest rates – on the basis that they don’t work very well in pushing current growth – were addressed. However, there is a potentially more pressing, and certainly quite well publicised, fear regarding interest rates.

Many argue that reserve banks have kept benchmark rates artificially low through their unprecedented quantitative easing programmes. Some worry that these low interest rates, and asset purchases by central banks, could be distorting markets and causing another disastrous bubble. A bubble is when asset prices are based on unlikely or inconsistent views of the future.

At a basic level, quantitative easing floods the financial system with new money in the hope that this will help drive bank lending and consumer spending. This is all meant to boost confidence in the economy, which creates a cycle of more lending and more spending.

However, the resulting low interest rates may also encourage overinvestment in the stock and real estate markets and in emerging economies not designed to handle sudden cash flows. This can lead to the formation of the kind of dangerous bubble seen in the real estate market in 2006.


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There is also an argument to be made that central banks are directly responsible for creating a bubble in government bond markets at least, with massive purchases pushing interest rates into negative territory in some developed economies.

Concern has been expressed that financial markets have become dependent on quantitative easing measures to prop up prices. If markets are reliant on easing, then any indication of a tightening would depress valuations. Indeed, earlier threats by the US Federal Reserve to raise interest rates caused serious jitters in global stock markets.

Fortunately, it seems like most investors have already “priced in” small rate increases in the near future. In essence, market prices reflect, to an extent, an expectation that rates will rise soon. This should prevent any increase from creating serious instability.

That said, concerns about conditions in asset markets are well-founded. Cyclically adjusted – corrected for fluctuations of the business cycle – stock market valuations are at unusually high levels, particularly in the United States. The consequences of a bubble would be devastating, so corrective measures are crucial.

Simply raising interest rates would do the trick. The excess money in the system would be removed, and there would be reduced investment in assets. However, interest rate adjustments are an incredibly broad tool. The ramifications to the economy of a premature increase in rates could be severe.

Countries may pay a price as they try to bolster markets and increase consumer spending.
Photo: AP

There does exist a more focused and nuanced alternative to interest rate increases: macroprudential policy. The word is a mouthful, and the measures can be rather complex in nature too. This describes measures targeted at specific problems in the financial markets. They differ from regulative measures in that they target instability in financial markets at large, instead of particular individuals or firms.

Such policy measures can include loan-to-value ratios to minimise the risk in property lending, liquidity requirements for banks,and mandatory provisions for banks to build capital buffers during boom times. They can effectively prevent the inflation of bubbles and ease stress on the financial system.

A number of countries have experimented with them, sometimes with mixed results. It is difficult to muster sufficient evidence regarding the efficacy of macroprudential policies. Those outlined above, however, are generally regarded as successful. A more detailed discussion of such measures would fill pages.

The attractiveness of such a policy lies in its ability to reduce systemic risk in the financial system, particularly in areas prone to distress,without jeopardising an economic recovery. The 2008 financial crisis compelled central banks to create and implement novel tools. To prevent the next one, they may have to do the same again.

Countries may pay a price as they try to bolster markets and increase consumer spending.
Photo: AP
 
This article appeared in the Young Post print edition as
The battle against the bubble

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