Bubbles: Remember to ask about the mechanism

By Matt Nolan 14/06/2013


I see that Bernard Hickey is suggesting we have the RBNZ pop the “housing bubble”.  And to do it the Bank should either ignore inflation targeting and hike rates, or do some magic with macroprudential tools!

The ideal RBNZ governor?

Assume a bubble, so lets start with one!  I have a list of problems with this type of article even given that ;) :

  1. I am nervous about giving non-democratically elected officials too much scope to do “distributional policy”.  This is the purpose of fiscal policy, and there is a thin line as soon as we start moving into alternative tools.  The Bank recognises this, but the rest of us have to as well!  (eg If we are sad about affordability, this is a fiscal policy issue – it has nothing to do with the RBNZ.)
  2. In terms of financial stability – which is in the Bank’s mandate – they only care about a bubble insofar as it risks bank failure.  So the solution is to try to get banks to hold enough capital.  Given that, who gives a proverbial about a bubble!  If people are willing to overpay in this context, and there are no broad macro ramifications, there is no role for central bank action at all.
  3. In terms of monetary policy, this matters only if it leads to an excessive increase in demand … in which case they lift rates due to their inflation mandate, there is no need to change anything in that regard.
  4. And now given you’ve ignored those three points, dear reader, let me throw in something you might not have thought about.  How in the name of frik itself do you pop a bubble?

This last point is important, how do you pop a bubble.  Lifting interest rates doesn’t usually do it – in fact if it is a “rational bubble” higher interest rates will lead to a larger bubble!

And if it is an “irrational bubble” why the hell will it care about a small shift in interest rates – if people are making magical capital gains, a marginal change in interest rates will be irrelevant to them.  Irrational bubbles are likely to be “interest insensitive”.  So interest rates miss the point.  And if the bubble is driven by “profit hungry leveraged investors” (so incredibly risk loving people), then LVR limits have no impact – as they would never be borrowing off banks in the first place!

We are talking about expectations here, and we are assuming (as we have a bubble that is against the Bank’s forecasts) that the Bank can’t control expectations.  Then we are saying “wave a wand and fix it somehow.

All four of these points tell me that having the Reserve Bank “deal with a bubble” is ridiculous.  In fact, I find the entire discussion about bubbles so amazingly ad hoc and inconsistent that I cannot believe I haven’t written this post before!  What have I been writing for the past six years?  (Here is a partial bubble history:  I see James wrote this on experiment economics.  I talk about Stiglitz and call him orthodox?.  I chat about the idea of using the CFR to control inflation – say no, it is more a “structural tool”.  I point to Marginal Revolution talking bubbles.  Bubbles and transfers from overseas.  Complaining new tools aren’t about stopping bubbles.  So yea, nothing actually talking about “what a bubble is and how it fits into policy”, opps).

And why aren’t more people making this point apparent.  This moves the entire debate to the issue of “are banks stable enough given systemic risk from an asset price realignment” and “is monetary policy appropriate given inflation and the output gap” … which is where everyone involved in policy would actually want it to be right?

It also tells me that political parties saying that will get the RBNZ to do more are really showing two things:

  1. They don’t want to take any responsibility for actual fiscal policy issues when in government (understandable, who would ever actually want to be in government!)
  2. They genuinely don’t understand monetary policy or what a “bubble” is – and just walk around talking like they do.  Hey, I can’t see a bubble when its floating around either – which is why I just try to think how it influences monetary policy and financial stability rules “before” passing judgment or opinion on what the Bank should do ;)

Honestly, the four point above are so incredibly fundamental, and so CONSTANTLY ignored, that I’ve had a lot of fun writing this post :D .  Now to get back to reading about solar power.