Monetary policy: preventing asset bubbles, leaning against the wind?

This week, I’ve done a lot of reading, in the train and during my internship (I could write a book on what I wrote as well). As I came across many (I mean seriously a lot of) interesting papers, discussions, and other pieces, one thing especially caught my attention and this is what I’ll shortly write about. At least, I’ll try to keep it short. Keeping it short is not my strongest point (in writing that is, in words I find it so much easier to be short and concise).

Anyway, the results of the stress tests were published last Friday. I hope to write more on that next week, as I’m definitely curious about how the markets analysed the results during the weekend and how investors will respond to the failure of 7 banks during the stress test. My guess in earlier blogs was that publishing the results would not cause any stress nor any relief, simply because the scenarios tested were not strict enough. On the other hand, some banks appeared to have done some (mainly accounting) tricks and thereby made the results look much nicer. Slight chance that the markets take that to be something unimportant. The fact that banks performed those tricks is a very bad signal, but I could be wrong; perhaps the markets are relieved still (hmm right, like I’m ever wrong). We’ll know more tomorrow morning.

Now what I really would like to mention is the following.

This week, the IMF in a research bulletin discussed how monetary policy could and should be used to prevent increases in asset prices that are not sustainable (asset bubbles that is). A perfect example is the housing bubble that burst in the U.S. in the summer of 2007. Common thought –and the message of an important research paper by Ben (Bernanke)- before the financial crisis took off, was that tightening monetary policy is a too rude policy tool to avoid asset bubbles. Rather, the bubble should burst and it was supposed to be the role of monetary policy to clean up the mess afterwards, using a loose monetary policy to kick start the economy again.

Some months ago, I read a paper by three famous IMF-economists: Olivier Blanchard, Giovanni Dell’Ariccia and Paolo Mauro. In “Rethinking macroeconomic policy”, they wrote that we should learn from the current crisis and that we should use more direct policy tools to fix the problems at hand. As the Jan Tinbergen-rule goes: one target, one policy tool. So: monetary policy is used to target inflation. Fiscal policy is used to make redistributions and the automatic stabilisers of fiscal policy work countercyclical. A disregarded policy that can be used well to prevent asset bubbles is regulatory policy. And this sounds so simple (although I’m sure working out the exact details takes some more time), but collateral requirements, capital and liquidity charges, and stricter lending policies make banks hold more capital and prevent credit overexpansion or give banks some leverage such that they can overcome external shocks. An example is Spanish dynamical provisioning that builds buffers in good times that can be used in bad times, to put it bluntly.

For more details, I want to refer to the paper of Blanchard, Dell’Ariccia and Mauro, which is really clear, well written, and credible. For now, I’m just wondering why the IMF wrote that monetary policy should be used (carefully, but still) to attack asset bubbles. Why is it that they disregard in some way the paper I mentioned.

I mean, if other policy tools could ‘do the trick’; why bother using such a rough measure to try to achieve the same thing, while at the same time it could seriously undermine economic growth. To me, it is like bombing the house to kill the nasty fruit flies in the kitchen, because I think it are these fruit flies that cause the rotten peaches. (Likewise, asset bubbles are hard to identify.) Definitely I’ll regret bombing the house if it turns out that the peaches will become rotten also without the nasty fruit flies in the –now bombed- kitchen.

The Federal Reserve and blood pressure

Yesterday I wrote on the U.S. economy and the Fed that will have to act someway or the other to at least try to avoid Japanese deflation scenarios. So as I promised, today you could have read the options available to the Fed. Not in my blog, but on the front page of the Wall Street Journal. Surprise!

First of all a word on my new colleagues: they are really great (they must be reading this sooner or later, so if I wanted to say something bad about them, I couldn’t anyway, for my own sake). The first day of my internship at iCC has past and I have to say that I look forward working there and doing the research for my master thesis (and for iCC, as the report is also in their interest), but more on this some other time.

Anyway, I don’t want to disappoint you already after my third blog (this will scare away the few loyal followers) so I will write here what I promised to write; let me quickly summarise what the article said (and which is, of course, exactly what I was going to write J).

So hang on: here is what the Fed could (COULD, not should) do:

1. Ideally, the Fed would strengthen its promise of keeping the fed funds rate low for an extended period of time, in order to encourage investors to borrow and take risks. Forecasts already expect the rate to stay close to zero well into 2011, so if this is not encouraging enough, what is? An yes, there is the problem of credibility. Because once investors borrowed, why not increase the rate?

2. A road the Fed could take is to push short-term rates to zero, but they are very reluctant to do so as it would disrupt the money market.

3. An attractive thing to do would be to use cash received from mortgage-backed securities or underlying loans that are paid off to invest in new mortgage-backed securities. At least, it seems to be an attractive option as it signals the Fed’s attempt to stimulate growth and so avoid deflation. A likely course of action, but the estimated impact is small, as mortgage rates are already very low so further stimulation is unnecessary.

4. Lastly, a very aggressive option would be to repurchase U.S. government bonds or mortgage-backed securities, to push down the long-term interest rate. The only problem here is that also this effect is likely to be small; the Fed would then have an even smaller portfolio to pour money from into the economy. The damage would be huge if the plan would backfire and inflation expectations rise.

So this was the theoretical part. Basically, the hands of the Fed are tightened and there are drawbacks to every option it has. Pumping money into the economy to get people to spend can stimulate growth, but whatever the Fed does, it comes at the cost of further increasing budget deficit and so it further constrains fiscal policy. What is really needed are tools to get employment up, fight falling wages and prices, but this is not the job of the Fed.

Currently the Fed is debating internally about what to do, and I think that is the best they can do; let them sit there and debate, because loosening monetary policy even more will do more harm than good. Let the U.S. government solve out how to fight unemployment and get spending and investment up.

To close with, I want to warn you. Research performed at the University of Chicago shows that loneliness can raise blood pressure. Such a relief: this holds only for those aged above 50. Don’t think: ‘time to start making friends before I’m that old’! First of all: 50 is not that old, I plan on becoming 110. Second, it’s not the amount of friends you have that determine how lonely you feel, but rather how long you can wait before someone write/calls you and how long you can stand to be alone (i.e. feelings of loneliness). Obviously perhaps, but nice that this gets confirmed by research.

The U.S. economy and the Fed

As a skip tonight’s news broadcast (just came back from a board meeting) and still have some time before I hit the bed but it’s too late to engage in some physical activity like my favourite dance game with the Wii, let me share with you my view on the U.S. economy. (That’s having your priorities straight.)

My curiosity on this topic was triggered by Paul Krugman’s blog on the Feckless Fed (btw. feckless means something like not fit to assume responsibility or being generally incompetent – nice word huh?). Paul Krugman is obviously pessimistic on the U.S. economy (rightly so), but moreover he is sceptical on how the U.S. Federal Reserve responds to the situation in the U.S., e.g. high unemployment rates, a huge government debt, too costly reform of the health system and already slow growth.

The first question that came to my mind was how it can be that the IMF in the world economic outlook predicts a growth rate for the U.S. of 3.3% in 2010 and 2.9% in 2011, while the prospects look so bleak. Of course, the states are recovering from the nadir and restoring from such a low does not require much. On the other hand, the fundamentals are really flawed and not much have been done to restore the financial system. The only good news in the last few weeks came from rallying stock indices and releases of macro-economic figures that were not too bad. However, these good figures and the following rallies again stem from increasing imbalances; too high borrowing from emerging economies and future generations. All in all, can we really believe these positive growth projections? I think we should be much more careful than taking these figures at face value.

The second question that came to my mind was when the Fed will make its move to avoid Japanese-style deflation and what move this will be. Paul Krugman’s worries about deflation are not completely ungrounded (and if they were, I wouldn’t dare to say so) and the Fed too has to confess that deflation in the near future is not completely unlikely to occur. So far, they have not taken any concrete action to do so. Even worse, the last statement of the Federal Open Market Committee suggests that economic prospects and the labour market start to improve gradually, but where does this recovery come from? There is only modest income growth and the housing market is still locked due to high unemployment. Okay, business spending is increasing, but confidence is decreasing, and many banks have not yet recognised their losses on commercial mortgage backed securities. The Eurozone economy does also not contribute positively to U.S. growth. These are the reasons for deflation not being completely unlikely.

If the Fed does not recognise this, surely they will not do anything to avoid deflation. If they would recognise it, what can they do? I range the options from hardly credible to somewhat more credible:

1. 1. ...

2. 2. ...

But this you can read tomorrow! J Sleep tight.

The criteria for stress testing

In my previous blog I have explained why publication of the stress testing results in the EU are not likely to have any effect. Below, I want to explain shortly why the criteria for the EU stress testing were set such as they were. Furthermore, I would like to add some additional comments on the stress testing criteria and its effects.

Previously, I stated that extreme scenarios were excluded from the stress tests because they would lead to too many defaults. However, there is more to it than that. First of all, including more extreme scenarios seems politically impossible; politicians do not consider sovereign defaults a likely scenario. The ECB and such will do whatever is in their power to prevent sovereign default. Market interventions play a role here: they will prevent such extreme scenarios to be tested. But the aim of stress testing is to check which banks will require capital injections should a sovereign default occur. Again, this is what makes the stress tests not credible. Another argument for not including extreme scenarios is that it is not that hard to imagine what would happen if some Southern European member states’ governments would default. But what is then the purpose of a stress test?

IMF research on stress tests, taking Iceland as an example, shows that stress tests do not have to be incredibly sophisticated, as long as the assumptions and scenarios (or the weight of the credit and market risks analysed) are appropriate. Too bad that this is ignored by the CEBS (Committee of European Banking Supervisors). Or actually the CEBS is not to blame; with its mandate being “giving advice to the EC on policy and regulatory issues related to banking supervision, promoting cooperation and convergence of supervisory practice across the EU, and contributing to consistent implementation of guidelines and recommendations” it has no regulatory power to require needed criteria for the stress tests.

My advice is to make to CEBR independent from national supervisors and Central Banks and give it the needed regulatory power to set more strict criteria for the stress tests, including:

1. Scenarios thought likely by financial markets;

2. Defining banks’ capital not as Tier I capital, but as the more stringent core equity (which would be consistent with the new Basel rules);

3. Require uniform disclosure of the results, and;

4. Require banks and governments to draw up contingency plans should markets panic after publication.

One last thing: short after release of the U.S. stress tests’ results last year, markets restored. We do not know whether this was because of the publication of the results in itself, or the required raising of additional bank capital (the U.S. contingency plan).

First blog of mine!

After being very patient while personalising the design of this blog, due to a really slow internet connection, it's time to post my first blog.

A few small things that were on my mind last week:

• Saying "With due respect, but..." shows no respect at all. So: it's better not to use this at all. Why then do we have this saying?
• Asking whether you can ask a question is not really productive.
• Neither is "to be honest...". Aren't you honest otherwise?

Apart from these language-related issues, I read some articles on the stress testing that is to be performed on 91 European banks these weeks (a list of which banks are included can be found here). A serious stress test would have been such a good idea: confidence could be restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently. And once clear which counterparty of banks are safe, banks can finally start lending to each other again, instead of parking their money on the ECB overnight facility at a very low yield.

Results are to be published the 23rd of July. Exciting? I'm afraid not! Although it seems quite scary that the ECB refuses to set aside capital in case markets panic after release of the testing results, and also national governments have no action plan stipulated when this happens, it is actually not so scary. Why not?

After a long time of debate on what the stress testing scenarios would look like, EcoFin decided not to include the scenario of sovereign default, while this is the utmost important scenario that investors worry about. For the stress testing results to be credible, this scenario must be included, otherwise it is not the sunlight that will bring the disinfection financial markets so desperately need (because they do what outsiders cannot do on their own: assessing the health of banks). My guess on why this extreme but still likely scenario is excluded is that it would lead to too many defaults, meaning that additional capital injections will be needed, while this is not what the ECB and governments are willing to do.

Unfortunately for Spain, the country that pushed the publication of stress testing results, the effects of the publication are likely to be minor in my view; investors will not stop worrying about the creditworthiness of EU banks. On the other hand: would we have wanted such severe stress tests that may banks would have defaulted in the tested scenarios? This seems even worse, since governments refuse to have a plan B ready if markets panic.

Perhaps in the future, when other stress tests will be done on European banks, scenarios will be severe enough, and governments will have learned to draw up contingency plans in case markets panic. But: not yet... A serious stress test could have been such a good idea: once clear which counterparty of banks are safe, banks can finally start to lending to each other, instead of parking their money on the ECB overnight facility at a very low yield. Confidence could have been restored and uncertainty lowered, thereby perhaps lowering the interest rates Southern European governments bonds pay currently.

I think in the above it has become clear why I do not believe that publication of the stress testing results would lead to a required capital injection of 100 billion euro, as stated by some analysts at the Dutch Rabobank.

Now it's waiting for publication of the results on the 23rd. In the meantime, I hope to keep you updated on other interesting stuff catching my attention.

Last but not least: the website of The Economist has been renewed. Looks quite nice now!