Sunday, May 18, 2008

“Double, double toil and trouble…

… Fire burn, and cauldron bubble”
The three witches in Macbeth, by William Shakespeare.

At my first job, more than a decade ago, I was given the nickname “bubble.” The term was coined by a British colleague, the result of a (rather esoteric) line of thinking on his part, having to do, not with Shakespeare, but with Cockney rhyming slang. I confess I didn’t find the name particularly flattering—I mean, “Chevelle” is far cooler! Yet, despite my protests, it was not long before I caught myself raising my head automatically upon mention of the word “bubble,” no matter the context!

So you can imagine the headaches I’ve developed recently, as the housing bubble is bursting here in America with a deafening “Bang!” Policy makers have been scrambling their heads, trying to devise ways to deal with the fact that some bubbles are less... “fun” that others!

The crux of the debate was eloquently put by Fed Governor Frederic Mishkin last week. Here is my paraphrased version:

Are some bubbles more dangerous than others? What should we do about them? Sit and watch, or take action? And, when it comes to action, what should that involve? Interest rates or regulation?

From bubble baths to NASDAQ: Some basic truths first: Bubbles can be quite inebriating—be it bubble gums, bubble baths, champagne bubbles or sky-rocketing stock prices at NASDAQ. As such, they also tend to be extremely inviting: Nobody wants to feel left out, so everyone floods in, the party gets crowded, and stock prices rise exponentially, reaching levels that cannot be justified by “fundamentals” (like corporate profitability, economic growth, etc). Meanwhile, if you are one of these “sober” voices calling for caution, the most likely response you’re going to get is "Have another glass!"

One day, Bang!! What next?

Well, it depends on the bubble. Bubble gums are pretty safe. Ditto for champagne bubbles: No matter how wasted you get, somehow, someway you’ll make it home. Stock market bubbles are a touch messier: The BANG will be usually accompanied by an impressive destruction of wealth, as the prices of your (and many others’) stocks decline calamitously.

Still, not that disastrous: You may have lost money, a LOT of money, but you still have your home, your car, your wife and kids. Your job too… if you’re lucky. And in the process, you may have even learnt a lesson: Next time, you’ll look for more “sensible” companies to put your savings at work, rather than investing in baloney start-ups with as inventive business ideas as online recycling of pet poo.

So these are the kind of bubbles it’s ok to sit and watch. But could there be bubbles that are more catastrophic?

Feedback loops: That’s what the Fed seems to think. Accordingly, bubbles that are fuelled by more and more borrowing can be particularly dangerous: Once they burst, they cause severe damage, not only to the “drunk ones” but to the financial system as a whole. Which in turn means that you and me, the “sober” ones who stayed away from the party, will also pay a big price in the form of slower economic growth, job losses, expensive access to credit, etc etc.

The recent housing bubble is a case in point. You had more and more people buying homes, as low interest rates and financial innovation (like the originate-to-distribute model) spurred growth in the issuance of mortgages. Home prices went up. Banks became complacent and loosened their credit standards: With rising home prices, they could always foreclose the property and get their money back if a borrower defaulted. So more mortgages were extended. Prices went even higher… more borrowing ensued… A vicious “feedback loop” that (next time!) should be stopped. But how?

Not me! That’s certainly what former Fed Chairman Alan Greenspan would have said. Ben seems to share that view: It’s not up to monetary policy (interest rates, basically) to correct the situation. And this for a number of reasons:

TiVo vs. TiVo Inc.: First, the objective of monetary policy is to promote a healthy pace of economic growth while maintaining price stability. When it comes to “price stability,” what the Fed cares about is consumer prices (e.g. the prices of cars or TiVos) not asset prices (e.g. the prices of homes or tech stocks).

Here is why: Asset prices send a signal to investors about the profitability of putting money into a particular business venture. They are therefore critical in channeling capital to (what are perceived as) productive economic sectors (be it technology companies or real estate). Any government interference in the form of, say, setting price “ceilings” on specific assets would distort the resource allocation process, compromising economic progress and efficiency.

Why me?! A second reason is that a bubble may be occurring in a particular class of assets—say housing—rather than in every asset. Therefore, by raising interest rates to stop that bubble from inflating further, the Fed will be hurting at the same time the entire economy. And why should I, the tomato paste producer, be paying higher interest rates because you, the online poo-recycler, are putting more and more money to more garbage “tech” ventures?

Is that a bubble? But there’s another problem: It’s actually not that easy to call a bubble a “bubble.” A bubble occurs when the price of an asset rises enough to deviate from a “fair” price that is based on “fundamentals.” And, as many will attest, it’s not easy to determine that “fair price.” Besides, if the Fed could know that price, why can’t investors? They’re both as smart and have access to the same information, right?

Regulate: With monetary policy “out,” the Fed seems inclined to pitch for regulation as the instrument for dealing with bubbles—the dangerous ones, that is. The objective would be to avoid those feedback loops between credit growth and asset price bubbles: For example, by re-linking the incentives for issuing mortgages to the quality of the loans rather than the volume; by re-establishing proper checks and balances on borrowers and their ability to pay; by improving the performance of credit rating agencies.

Some also are talking about the Fed assuming new powers that would allow it to influence the behavior of financial institutions if this is deemed to lead to systemic risks. Others have proposed making banks’ capital requirements “anti-cyclical”: That is, during good times, banks would be required to increase the “cushions” of capital they are required to hold, making it more expensive for them to lend more, and thus curbing their overall lending.

As you can see, ideas abound, and not all are flawless. But the environment is ripe, the frustration real and the chatter louder, so expect to see regulatory action sooner rather than later.

Meanwhile, we can all continue our detoxicating period with another glass of… water. Bubbly, of course!

Glossary: asset prices, consumer prices, bubbles, fundamentals, capital requirements, cockney slang, Macbeth.

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