Tuesday, December 15, 2015

Tilting at Bubbles

Source: Wall Street Journal
The Wall Street Journal reports on the "Fed's Unsolved Puzzle: How to Deflate Bubbles" (That's the print version headline, much pithier than online.)

I thought I was reading The Onion. There it is, a graph marked "Asset Bubbles," measured, apparently, with interferometer precision.

I must have been asleep or something, since the last time I touched base with finance, mid-yesterday, we still didn't have an operational definition of "bubble," let alone a way of measuring one, beyond academics and Fed officials looking out their office windows and opining that prices seem awfully high (but not quite enough for them to put on a big short.) Let alone any scientific understanding of what policies might calm such bogeymen. How does the Fed know a "bubble" from a "boom," an "irrational valuation" from a rational willingness to take risk in a slow but steady real economy?

And, much more importantly, when did it become the Fed's job to diagnose and prick its perceptions of asset price "bubbles?"

Yet here we read
Six years after the financial crisis ended, the central bank remained ill-equipped to quell the kind of dangerous asset bubbles that destabilized the savings-and-loan industry during the late 1980s, tech stocks in the 1990s and housing in the mid-2000s.
...financial bubbles have been root causes of the past three recessions
 Iowa farmland prices rose 28% between the fourth quarter of 2010 and the fourth quarter of 2011, igniting fears of a dangerous bubble
Apparently "bubbles" have made their way from Monday-morning quarterbacking to established and measurable facts. (To clarify, this is a news story not an editorial, and the reporters, Jon Hilsenrath and David Harrison, are just passing on what they hear. )
Commercial real-estate prices are soaring and Fed officials face the conundrum of what, if anything, to do.
Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms.
Even though many Fed officials favor using regulatory powers over interest rates to stop bubbles, the U.S. was a “long way” from establishing a regulatory system that could achieve that, Mr. Dudley said in September. 
Your darn tootin' they face that conundrum. Because diagnosing the sources of, and controlling, asset and real estate prices is not, and never has been, part of the Fed's job. 

The Fed has great power and independence. The price of that power and independence is limited sphere of action. It's also wise. Once the Fed becomes the central planner of real estate prices, and allocator of credit to control prices, it will neatly be sandwiched into a political role. Sellers and developers want more, and chant "prices are depressed, stimulate." Buyers want less and chant "pop this bubble" (but give me credit to buy.) The only possible answer is, real estate prices are just not our business.

Central banks have always been severely limited by statute and tradition to what they can try to control, and what tools they can use, in return for their independence. Traditionally, the central bank bought only short-term treasuries, and controlled only short-term interest rates, and its targets were limited to inflation and employment.  Intervening in mortgage backed security and long term treasury markets is already a stretch. Using interest rates to target asset prices is a stretch. Using regulatory power, to allocate credit, to control real estate prices, is way, way beyond the Fed's mandate.

Memo to Fed:  There is already a chorus angry at how much you exceed your sphere now. You may regard them as ill-informed peasants with pitchforks, but they happen to occupy seats in Congress and they're writing bills. If you decide to judge whether the price of farmland in Iowa is a "bubble," and to use your regulatory powers to stifle credit to Iowa farmers with the goal of determining the just price of farmland, those peasants with pitchforks aren't going to take it quietly.

The Fed has neither authority, mandate, road map, nor regulatory measures, because controlling real estate prices is no more its job than controlling carbon emissions. Congress could change that, and give the Fed broad authority. But it has not done so.

To be fair, perhaps this is a natural extension. The Fed took on the job of propping up house, bond, and arguably stock prices in the recession, and there is not a huge outburst of complaint. Perhaps therefore it is entitled to tamp down house, bond, and stock prices in a boom, if it so desires. Oh wait, there is a huge outburst of complaint.
Mr. Rosengren [president of the Boston Fed] had noticed more building cranes in Boston.
“Given our low interest rates, given that it is an interest-sensitive sector, it is probably worthwhile to start thinking about at what point do we become concerned that is growing too rapidly,” he said.
The Fed’s low interest-rate policies have helped drive investors into such assets as commercial real estate as they search for higher returns.
Fed officials said afterward they saw they lacked clear-cut tools or a proper road map of regulatory measures to help stem the simulated booms. (Repeated, with emphasis) 
The vague rationale for intervention is that there is a difference between "boom" and "bubble," between asset prices that are high because of "real" valuations vs. "irrational" ones, between something like "supply" and "demand" and somehow the Fed can tell in real time, offset the bad and allow the good. But that all disappeared in the above paragraphs. Boom and bubble are now the same. And we're not even talking about national or "systemic" "bubbles" anymore. Now the Fed is supposed to worry about the price of farmland in Iowa

This is how it's supposed to work. The Fed lowered interest rates, that raises asset values, higher asset values induce people to invest, which is "stimulative." Q theory 101. How do we know it's "too much?"
Despite the action in commercial real estate, debt levels across the broader financial system are still modest. Overall U.S. financial sector debt— $15.2 trillion in the second quarter—was down 16% from the third quarter of 2008. Financial sector debt has fallen to 84% of economic output from 125%, a sign the economy is less prone to a financial crisis on the scale of 2008.
“Our quantitative measures indicate a subdued level of overall vulnerability in the U.S. financial system,” Fed economists said in an August research paper that sought to assess risks of banks and markets overheating.
Now we're getting somewhere. How are asset price gyrations a "risk" anyway? Answer: if and only if they make their way through debt to default and runs. The right answer to such worries is to make sure there isn't a lot of debt in the way, and let asset prices do whatever they want to do. Keep people from storing gas in the basement; don't try to stop them from ever lighting a candle. The project that the Fed will micro manage prices so nobody ever loses money again is hopeless.

And the bottom graph looks pretty darn good. So what is the worry? If there is no debt in the way, why must the Fed try to control prices?
Some of them, including Ms. George [president of the Federal Reserve Bank of Kansas City] said rates weren’t the right instrument to use against bubbles. She favored demanding banks hold more capital.
Excellent! (I presume she was misquoted, as banks issue capital, they don't hold it, but a minor quibble.)

The graph: I looked up the original here, in a nice paper titled "Mapping Heat in the U.S. Financial System." The paper does not pretend to define or measure "bubbles." It's a nice index number/visualization/forecasting exercise with many more pretty graphs.


  1. The bank system advocated by John Cochrane (link below) would help reduce bubbles.


    That system (i.e. full reserve banking) severely constrains money creation by private banks, i.e. only central banks create money to all intents and purposes. Given that private banks create and lend out money in a very pro-cyclical manner, putting an end to private money creation should iron out cycles and bubbles a bit.

    1. And John also mentions in his article that:

      "The Fed has neither authority, mandate, road map, nor regulatory measures, because controlling real estate prices is no more its job than controlling carbon emissions."

      So John's recommended banking policy would enable the central bank to perform a job that John believes it should not do.

  2. Great post John. As long as they are now defining bubbles, do they care to concern themselves with how their past interest rate policies have helped to create or quash them?

  3. "Bubble" is now used in finance like "-gate" has been used for scandal. There's a Wikipedia entry that lists dozens of "gates". After a while a term is used so broadly as to almost lack any information. It reminds me of when my daughter was learning to speak and she called every animal a cow.

    The fundamental problem I have is that asset valuations, no matter how you measure them, are in a a continuous domain, whereas "bubble" seems to imply a certain magical threshold has been reached, identifying a category. We are trying to derive categorical data from continuous data.

    I see this in my own profession all the time and wrote about it eons ago when I was in academics. In an attempt to determine the risk of aspiration of gastric contents under anesthesia someone, somehow, set a threshold of 2.5 as a "safe" pH and 30 ccs as a "safe" volume. So if you aspirate gastric contents with pH = 2.55 you're far better off than 2.45, and 29 ccs is much better than 31? BTW, it's not uncommon to give patients 30 ccs of an antacid before anesthesia. That patient is now by definition over the line. I have never run into a colleague who was disturbed by this.

    Then there are "quality scores", where a score of say, 90, is a pass and 89 is a fail.

    Maybe bubbles are like time:

    "What then is time? If no one asks me, I know what it is. If I wish to explain it to him who asks, I do not know." -- Saint Augustine

    Richard Feynman demonstrated to his class the difference between noise and music. He threw several pieces of wood of various sizes at the wall, and said "That's noise". Then he threw the pieces in a certain order to play a tune. "That's music."

  4. Thank you for this. Measurement (and measurability) seems to be lost on policy makers. But perhaps this is also because they need to seem to be doing something, even if they don't quite know why or what.

    Also, you've quibbled (now and in the past) with the definition of capital (issue vs. hold). Economists normally think of capital as a stock variable, which might explain what they have in mind. You seem to be thinking of it as akin to credit. Can you provide a precise definition of capital (and credit etc.) so we know what exactly you have in mind?

  5. Valter Buffo, Recce'd, MilanoDecember 16, 2015 at 10:23 AM

    Quote: This is how it's supposed to work. The Fed lowered interest rates, that raises asset values, higher asset values induce people to invest, which is "stimulative." Q theory 101. How do we know it's "too much?"

    The whole point of this discussion lays here. Since we DO NOT know, the why are they using asset prices as a policy instrument? How do they measure risks (as for instance mis-allocation of capital)?

    The mean-variance-covariance tradition in asset pricing ignores (porposedly in my view) that an intertemporal budget constraint MUST be the link between current asset prices and future real economy returns (hard data and not "expected returns"). Asset pricess cannot get to ANY price with no real-economy consequences.

  6. I agree, it is not the Fed's job to fight bubbles. It has enough on its hands fighting prosperity and rather low rates of inflation.

    1. Re getting inflation up, I agree that vexed question is occupying some of the greatest minds in economics at the moment. However, if the Fed hired Robert Mugabe as a consultant, he could explain how to do it in ten seconds. That would leave the Fed more time to deal with bubbles. What do you think?

  7. There is a bubble in housing:

    "The Bigger Picture for Median U.S. New Home Sale Prices"

    It shows up very clearly in the graph of median house price vs median household income.

    And it is the Feds doing, it is what they have been trying to do. They will now try to let the air out of the bubble without an explosion. Good luck with that guys.

  8. Well, in the last five minutes I have changed my mind about bubble and bank regs.

    Here goes, and I think John Cochrane will like this.

    No regs on banks (that want FDIC deposit insurance that is), except that they keep reserves, say for argument sake, at 20% of assets (equity to loans outstanding). A one-paragraph regulation.

    That's a good cushion, and up from 12-13% now.

    Okay step 2, the banks' first layer of debt, also a minimum of 20%, is convertible bonds. That is the second and last paragraph of the regulations concerning banks that want FDIC insurance.

    So, we should have (in a pubco bank) a board of directors, representing shareholder interests. They do not want the bank to go belly-up. The second layer is convertible bondholders, and they will take over if the bank fails, and convert their debt into equity. Likely, when trouble happens, the convertible bond-owners will form bondholders' committee, appoint new management, and we are good to go.

    If those two layers fail, the third layer is the Fed, and they then print money and re-cap the bank. The Fed buys Treasuries and gives them to the failed bank, and then sells the bank to the private sector. In the past, there would have been wailing about inflation with this plan, but jeez, we have done $4.5 trillion and inflation is dying globally, so no worries there.

    Actually, under this plan, when the bank is sold to the private sector, the taxpayers should come out ahead.

    So, why do we worry about real estate bubbles? As we fear banks will get crumped, hurting everybody else. My plan solves the problem.

    There is still a macroeconomic (not macro-prudential) problem of banks pulling in horns in unison in downturns, thus undercutting the economy, The Fed has to go to heavy to QE when that happens, hopefully in combo with tax cuts.

    And remember: The goal now should be Full Tilt Boogie Boom Times in Fat City. Please, no more sanctimonious sermonettes from little boys in short pants about inflation.

  9. My view is that the Fed has a duty to protect the stability and liquidity of the financial markets. In the absolute troughs that means stepping in and buying commercial paper through programs like the "Commercial Paper Funding Facility". At the peaks the Fed should be investigating the reasons for high asset prices and determine whether there is a risk to financial stability. The Fed should not try to control asset prices directly but view anomalous prices as an indication that something is wrong in the financial system.

    A bubble in house prices might be a result of some combination of irrational exuberance, wrong estimates of the course of future inflation (that one cost me $25,000 in 1981) or widespread fraud in the origination and packaging of mortgages. To the extent that an asset boom is "inflation", the Fed has a right and duty to react to the asset prices in the name of controlling inflation.

    I have ambivalent feelings about the Fed's purchase of long term assets. The Fed buying MBS crossed over into fiscal policy which I think is impermissible for the Fed. The Republicans in Congress were doing their best to flush the economy down the toilet and the Fed took steps to off-set Congress's efforts. As a constitutional matter, and as a long term lesson in political and economic consequences, my view is that the Fed should not have purchased MBS. The Fed was re-investing principal payments received on MBS. The Fed should come out and say that effective January 1, 2016 they will stop rolling over principal.

  10. While it's always useful to oppose further Fed (or general government) interference in the economy, almost everyone in the real world acknowledges that the Fed has been attempting to be “the central planner of real estate prices, and allocator of credit to control prices” since at least the mid 1990s.

    It's going to take a far worse disaster than the one we all experienced in 2007-2009 before the central planners are thoroughly repudiated. And that's assuming that some sort of Trump-style neo-fascism doesn't become the prevailing response.

  11. "Because diagnosing the sources of, and controlling, asset and real estate prices is not, and never has been, part of the Fed's job."

    Truth. Neither is covering losses of massive market players when boom turns to bust.

    Possibly, bubble run-ups will become rare if the Fed sat on its hands and watched as players/speculators (lenders/securitizers/equity holders) massively get their fingers burnt.

    I think The Fed was a smaller player in the run-up to 2007. Rates were not unduly low and I don't believe the money supply measures rose that much. Wall street (2008 with TRAP many became bank holding companies subject to Fed regulation and supervisions), FDIC-insured banks, FHLMC/FNMA, et al provided the liquidity that needed to feed the huge run-up in RE prices.

    Despite major CRE losses in the S&L and 1990 North East RE crises, beginning around 2004 players acted as if RE prices never decline.

    Some measurements that could be tracked may be stock, bond and RE price increases compared to median disposable income (for residential and rental RE) growth and GDP growth. For CRE, survey appraisals to track how low capitalization rates (variously NOI to sale price, gross rents to sale price, etc.) decline. In the hottest 2004 - 6 CRE markets, direct cap rates were as low as 4%. What equity investor would accept a 4% return unless he/she believed that the market value of the property would skyrocket?


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