In 21 industrial economies during 1970-2008, there have been about 47 housing price busts and about 90 stock price collapses. Sometimes they both overlapped, other times not. There is now concern that stock markets in Emerging Markets have expanded rather rapidly since their lows at end-2008. There are worries that the fiscal stimulus packages and monetary easing policies that we put in during the crisis months of October 2008 to June 2009 may have sowed the seeds of the next bubble as private sector credit has increased sharply in several emerging economies.
In several of these episodes of busts, in the run up to the asset price bubbles, there has been a rapid growth in the credit. In the recent crisis, not only in the industrial economies but also in the emerging economies, particularly Emerging Europe, housing prices rose sharply in the run up to the crisis and were often associated with a rapid credit growth resulting in an escalation of household leverage and debt. So asset price rises were accommodated by credit booms. In turn, the credit booms were associated by an increase in capital inflows. Credit booms, in turn, drive increases in housing prices and/or stock prices, and/or exchange rates. There is therefore a feedback loop, that fuels increased household and financial firms’ leverage, and lowering of lending standards (as reflected in the sub-prime loans in the United States). The longer the credit boom goes on the higher the probability that it will end up in a financial crisis.
Asset booms and busts are now the new normal. The question then becomes: how should monetary policy respond to a run up in house or stock prices? But the identification of bubbles and credit booms is fraught with problems. Should credit growth of 1.5 times the nominal GDP be considered a credit boom? Is credit increasing rapidly due to financial liberalization, financial development or due to loose monetary policy or just increase at the same pace as real output?
Should monetary policy respond to a boom? The consensus view before the crisis was that monetary policy should focus on keeping inflation low (as this is conducive for growth). Asset prices are monitored for information related to the economic situation but never targeted by central banks. For example, there was a boom in stock prices in most emerging market economies but seldom did their central banks attempt to contain the ‘irrational exuberance.’ This narrow focus of monetary policy is based on the view that it is difficult to differentiate between a speculative boom and episodes of rational decisions by individuals. Moreover, monetary policy may be a blunt instrument to stop a boom and it may end up doing more harm to the whole economy while trying to contain a boom. For example, during booms, the expected returns on assets may be so high that small changes in policy interest rate may have little or no effect on investors’ decisions. However, higher interest rates can lower demand and supply of bank loans and could have mitigated the US and European housing boom. Similarly, raising reserve requirements can sometimes be effective in limiting credit growth in domestic currency. As discussed below, flexible prudential regulations and tightened supervision may be better tools in managing a boom.
Growth in credit and financial leverage should be monitored for systemic risk. The ratio of credit to GDP and its growth is a useful warning bell of boom conditions and leverage. Other leverage indicators could be data on borrowers and analysis of balance sheets of firms for exposures. Details of capital accounts in balance of payments could provide useful information about unsustainable leverage positions and can provide an early warning about ‘good’ and ‘bad’ booms. In addition, housing price and real-estate price booms typically involve a high degree of borrower leverage. Depending on individual country circumstances, Central Banks should develop a range of measures to assess systemic risks. These measures should include firm-specific measures and system-wide risks, including leverage and foreign exposures.
What should policy makers do in future? The 2008-09 financial crisis was in part due to unusually high over-leverage ratios of 40 to one by financial firms in US and Europe. Credit flows to real estate was way too high compared with credit for small-and-medium enterprises in these countries, in part due to tax-incentives (low interest rates and tax deductions for mortgage interest) and the politicization of housing (the so-called American dream to own a house). The ongoing global crisis necessitates that at least for the next 2-3 years there will be de-leveraging, rising deficits-debt-default, and re-regulation. At the same time, there is the danger of prematurely withdrawing fiscal stimulus and monetary easing that may send the economies into another tail-spin. To minimize credit bubbles in the future, there is a need for policy makers to:
- Develop an international system of monitoring leveraging by banks and financial institutions, particularly the large ones, including leveraging among the various sectors in different geographical areas. There is a need for developing such a ‘heat map’ because central banks are usually unable to identify credit bubbles but can monitor leverage ratios at micro and macro levels.
- Encourage banks to develop risk models to include leverage ratios and internal risk-adjusted weights in each of the real sectors. Can private sector risk managers do it by themselves? Not really; the private sector has invested heavily in risk management tools and progressed quite a bit in quantitative and qualititative tools but they would need global institutions that have an advantage in comparing and contrasting across countries and sectors and firms. Stress-testing by private sector has failed. The behavior of financial firms and their counterparties has been disappointing during this crisis because the best risk-management would have been for the credit agencies to insist that mortgage originators should have a stake in the debt instruments at all times.
- Regulate pockets of leverage (e.g. trade brokers in certain institutions), including ensuring more capital for such highly-leveraged firms or by increasing margin requirements or by restrictions such as loan-to-value ratios for housing loans. Capital requirements are necessary but not sufficient.
- Phase out the distortions arising from bias in terms of directed credit and tax exemptions for the real-estate.