Monday, April 6, 2009

Bubbles and Systemic Risk

There is a wide-spread concern that the current monetary easing plants the seeds for the next bubble and therefore for the next financial meltdown. The logic is clear – between 2001 and 2004 Greenspan lowered interest rates to clean up the bust and as a result of the low interest rates a bubble in the housing market materialized. Over the past few months, Bernanke went well beyond Greenspan’s expansionary policy by lowering rates to 0%, by starting credit “defrosting“ programs as well as by implementing the so-called “quantitative easing”. The ultimate side effect of these efforts to resuscitate the economy must be again a bubble.

Whether a bubble will develop or not in the immediate future is not entirely clear. In this entry, however, I want to use these concerns in order to put up two topics for discussion: (1) Not all bubbles are the same; (2) The big issue is systemic risk – with or without bubbles.

1. Not all bubbles are born equal. The fact that a bubble may develop does not necessarily mean that we will get to the same catastrophic dynamics as in the past two years. Suppose that a bubble develops in the market for gold and the price goes to $3000 per ounce. At some point investors may realize that demand is faltering, they will start selling their holdings of gold and the bubble will deflate. Although for some investors the collapse of this bubble will generate uncomfortable redistribution of wealth, it is not going to lead necessarily to a financial meltdown. Even the bubble did not generate the same kind of dynamics as the ones we saw after 2007. The gold bubble and the bubble are very different from the house price bubble. In my view, the key distinction is whether the bursting of the bubble generates systemic risk for the banking sector. One of the fundamental reasons for the severity of the current recession is that credit markets froze because banks had too much uncertainty about their survival probability and they stopped lending. In plain words, the collapse of the bubble had implications for the entire economic and financial system. Not all bubbles have such effects.

Inevitably, there will be more bubbles in the future. There is little doubt that euphoria in some markets at some point will lead to a disconnect between fundamental values and current prices. Whether policy makers should address a bubble and by what means depends to a large degree on the risk of having an economy-wide meltdown once the bubble starts deflating.

2. From regulation to systemic risk policy? The dynamics of the vicious circle between the contraction of the real economy and the disintegration of the financial sector is reminiscent of the dynamics that led to the severity of the Great Depression. Roosevelt arrested these dynamics by implementing four policy changes: (1) financial restructuring (after the banking holiday); (2) expansionary monetary policy (allowed by the suspension of the gold standard); (3) fiscal expansion (i.e. the New Deal; I know that it had a small contribution to the recovery, but at least fiscal policy was not in the way of other policies); (4) regulatory changes (the Glass-Steagall act, etc.). Since the start of the toxic interaction between the financial collapse and the real economy contraction after the collapse of Lehman brothers, I have argued that policy makers have to act in the same four dimensions in order to stabilize the economic activity. This is hardly an original thought, but it is useful to remember that these were also the actions of the Roosevelt government.

At an event organized by INSEAD on April 3, 2009, I made the same argument and in a panel discussion after my presentation, Sir Andrew Large – a former Deputy Governor of the Bank of England – suggested that there is a fifth item that should be added to this list: policy related to systemic risk.

So far systemic risk has been in the realm of regulation. We can think of various restrictions on lending, leverage, capital adequacy ratios, etc., which are designed to minimize the risk of a system-wide collapse. The point of Sir Andrew Large was that these are static measures, but given the sharp increase in financial innovation and the rapid changes in financial markets, shouldn’t we think of a policy body that continuously reviews and changes some of these ratios on a dynamic basis? In the way that monetary policy changes interest rates, the new policy authority will have a set of instruments to deal with developments that raise systemic risk in the economy. Naturally, this body will be in charge of addressing bubbles that have systemic implications. However, it will not be just a bubble-buster, since systemic risk can arise even in periods without bubbles.

There are certainly pros and cons in implementing such a dramatic institutional change and I am sure that I do not do justice here to the ideas of Sir Andrew Large. But I think that this is a very original idea and it deserves further consideration.

Ilian Mihov