March 19, 2006

Financial markets attempt to stop the runaway money train

Posted in International Economy ·

In the past few weeks, the world�s financial markets have begun to worry again about the huge amount of money sloshing around the globe. So many assets have risen in value simply because there are billions of dollars of excess money seeping into every nook and cranny of the financial system. Where is the money coming from and how can central banks manage the asset bubbles building?

No-one wants a global fall in asset values which might precipitate a global recession, so the question is how do the world�s central banks deflate housing markets, commodity markets, stock markets and emerging markets in an orderly fashion. This is a very difficult act and one that has not been managed before.

Typically, when the world interest rates cycle turns, investors get burnt badly.

Further, because of the integration of the financial markets, a tiny change in one part of the world can have major unforeseen consequences in another part of the globe.

For example, this week the stock and property markets of the Gulf States took a hammering. In one day, the Dubai stock exchange fell by 11 per cent.

Why was this? Did oil prices fall or some political event in the region trigger investor panic? No, it was because (and this might be of interest to those hundreds of Irish people buying property in Dubai) the Bank of Japan indicated that it might be putting interest rates up (minutely) by the end of the year.

What has this got to do with Dubai?

Well nothing really, until we appreciate that the bull market in the Gulf States was in part financed by what are called in the business ��carry trades��. This is where an investor will borrow in Yen, because the interest rates are effectively zero, and finance investments in a rising market like Dubai.

The stocks are used as collateral. The higher the Dubai market goes, the more money will be lent to the investor because the greater the value of his collateral. At the first suggestion that Japanese rates might rise, the investor sells his Dubai position despite the fact that nothing negative in Dubai has occurred to prompt this. And, as the stock market falls, more money is withdrawn because the ��value�� of the collateral has fallen.

So the more borrowed we are globally, the more sensitive assets are to minute changes in faraway central bank policy.

Given what occurred in Dubai this week, can you imagine what might happen if the ECB, Federal Reserve and Bank of Japan were to raise interest rates at the same time? Obviously some assets are more fragile than others, but there is a real chance of global panic.

The nub of the problem is the way in which banks (lenders) value collateral in a boom. There is an inbuilt self-propelling mechanism that exacerbates the upswing and the downturn.

As the ��value�� of the collateral rises, the bank feels that it is prudent to lend more money against that asset. So in the case of Dubai, as long as the stock market was rising, banks kept lending to investors, who kept placing bets. We can see the same thing happening here in our property market.

Let�s look at the example of a house worth �400,000. It is used as collateral to borrow �370,000 to buy another property for investment. The extra �370,000 goes into the system.

The golden rule of monetary economics is that the more money in the system, the greater the upward price pressure on all other things. Thus, the extra cash sloshing around in the system puts upward price pressure on houses because there is too much money chasing too few houses. This makes the original collateral now increase in ��value�� to �430,000. And so on. The bank extends another loan on the same collateral, failing to distinguish the chicken from the egg. In time the balance sheet plays tricks on the banks.

Because of this self-propelling mechanism, the system has no break and it is impossible for it to slowdown of its own accord. Not only does the machine not have a reverse gear, it has no neutral and feels like a car constantly revved in third gear. Critically, these phenomena cause booms and troughs to be amplified.

So what can be done? An interesting solution might be for our banks, and banks around the world, to adopt a simple moving average of the asset price upon which to base their lending rather than the price today, which is the case at the moment. So, for example, here the central bank could advise the commercial banks to use a 10-year moving average of house prices. This would reflect a typical asset price cycle.

It would have the advantage of stabilising credit swings. Credit expansion (and house or asset prices increases) would be mitigated in boom times, as would the pressure to withdraw loans and mortgages when things turn sour. This approach would smooth the asset cycle and with it the peaks and troughs in prices.

In the course of the next few years, the central banks around the world have to grapple with the idea that the most serious consequence of today�s credit bonanza is not inflation � as was the case in the 1970s – but large rises and falls in asset prices.

The experience in Dubai this week suggests that we do not understand the fragility of the market. This sensitivity is particularly worrisome when the United States continues to print paper money to pay for its imports. The recipients of this paper money – US dollar denominated T-bills – are those countries with a large trade surplus with the US, namely, China, Japan and Germany.

As long as the US continues to live in hoc, cheap money will flood the market, causing asset prices to rise. But as we saw in Dubai, this can change rapidly, leading to sharp falls.

What might happen if the countries which at the moment are lending to the US decided that they no longer wished to do so? Or what if they demanded a higher rate of interest/return for the pleasure of holding American assets? This could cause wild swings in asset prices around the globe affecting the price of our houses, our pensions and our general prosperity.

Surely a better outcome would be to introduce a ten-year moving average to govern the value of collateral that determines how much can be lent. This might be dull, might not give us the roller coaster ride that some investors thrive on, but it would protect the average punter, which is what should be the primary aim of a strong financial system.

  1. Seán

    Taken completely out of context from the new testatment, but
    it’s apt to those buying property in Dubai and other
    property hotspots.

    Matthew 7:26-27 And every one who hears these words of
    mine, and does not do them, is like a foolish man, who built
    his house upon the sand:
    And the rain descended, and the floods came, and the winds
    blew, and beat upon that house; and it fell: and great was
    the fall of it.

    Does anyone realise that some of these property
    “investments” offered abroad to Irish people are in areas
    that are subject to Hurricanes (Carribean & Miami), Flooding
    (Shanghai), Water Shortages (Dubai, Cape Verde Is.) and
    earthquakes (Turkey and Bulgaria).

  2. PC

    Just take at look at the unbelievable rate of construction
    in Dubai…

  3. noel

    could the central banks not increase the reserve ratio that
    banks should have to hold in line with the increase with
    money supply.

    i mean if a bank holds 10% nominal, and money supply is
    doubled, then in real terms all the hold is 5%, increasing
    the knock on money multiplier.

    the inc in reserve ration would slow down asset price rise
    as there would be less money floating around to push up the

  4. John Doe

    First Spain, then Bulgaria and Poland, now Cape Verde and
    Dubai not to mention an assortment of obscure locations,
    that a geography teacher would be hard pressed to find on
    his atlas. I’m beginning to wonder if Irish people are
    culturally programmed to speculate.

    The Albanians seem to have had a similar widespread
    speculative mania in the mid 90’s when several pyramid
    scams gripped the nation.
    In Albania the inevitable crash in the pyramids lead to
    widespread civic unrest, violence in the streets and the
    ruination of their economy.

    However, given the facts that Albania had just emerged
    from nearly fifty years of communist dictatorship and the
    country was economically still in the dark ages; excuses
    to some degree the gullibility displayed by the populous.

    Now fast forward to Ireland a supposedly sophisticated and
    wealthy nation. What have we learnt from the misery of
    these peasant people over a decade ago? nothing. Pyramid
    schemes are gripping the nation once again, reports are
    emerging that schemes are starting in schools,
    that the credulous are borrowing money to get involved,
    burning tractors light the night skies as reality dawns,
    friends and neighbours are fleecing and being fleeced by
    each other, deep and lasting resentments are being
    twisted by this utter madness.

    When the dust settles on the great Irish speculative
    economy of the turn of the millennium, we will be held up
    to ridicule the world over. Economists will rush out new
    editions of their works with new chapters dealing with the
    Celtic Tiger Crash; economics students decades from now
    will still study the causes and effects of Tulip mania but
    in conjunction with the Celtic Tiger Crash.

    I salute you David for your efforts to caution those in
    the throws of irrational exuberance, but I fear that we
    are beyond salvation. But at least unsustainable house
    price inflation has eased.

  5. ian

    Hello David,
    I salute you as well. I think you have a very good educated
    mind and are trying to influence us all against the perils
    of speculation. when will this end? how much will the price
    of houses drop? These are the questions that fascinate
    people on a day by day basis. I believe the economic
    turmoil of the eighties could have been blamed on the lack
    of foresight of the government of the day. The future
    economic problems can be blamed on the greed and
    foolishness of the people of the today.
    congrats again david on a good website and very good

  6. adrian

    Monetary policy of the last 25 years or so has set about
    maintaning a stable economic environment with low inflation,
    an environment suitable for steady sustainable growth.

    With hindsight its now obvious enough that asset price
    growth should be built into the inflation measurements. The
    UK (central) Bank nudges interest rates up and down as
    inflation ebbs and flows. House price moves are not
    officially supposed to influence the uk interest rate
    decision but in practice house prices are also taken into
    In euroland the chief economists are in a procedural
    straight jacket with rates physically linked to
    goods/services inflation. They have deep seated fears
    regarding asset prices but have no tool available to cool
    the market.So whats the solution? Property hotspots tend
    to be localised in a european context, Spain and Ireland
    being the big 2.
    Perhaps the central bankers could identify geographical
    areas of overvaluation and impose a tax on new loans
    secured on property those areas. Sell AIB sell sell sell!

  7. Dan

    Another fine article David..

    Dubai has proved to be just the start of a reality check for
    those so called investors whom have bought property abroad…
    Every man and his dog who has made money in Irelands
    property boom now has an opinion on where you should buy

    Spain,Dubai,Bulgaria, South Africa are all on the irish
    investors radar and the problem is that just because you got
    lucky once doesnt make you an investor, as some of our
    “international property speculators” may find to there

    As Buffet once said: “when the tide goes out we then see who
    was swimming naked.”

    And also: ” it amazes me that poeple spend more time chosing
    a fridge than looking into an investment”

    People dont seem to realise that they may be left with a
    expensive mistake.

  8. Mike

    There was a small article in the Irish Indepedent business
    section today (23/03/06) that AIB was planning on selling
    all of its Irish property. The author made one specific
    point that was interesting and I quote:

    ” In one way it could mark the pinnacle of the current
    property boom, as the bank would be unlikely to sell off its
    bank branches this year if it expected their value to go
    through the roof over the next few years.”


  9. Pat MrCarten

    I wonder if you could have a look at a small country much
    like Ireland – New Zealand – which has now ran out of
    immigrants, and comment on whats happening there.

  10. Mark

    Hi David,

    Another excellent article and an interesting idea but as a
    general idea does is not go against the spirit of free
    market economics somewhat? Ultimately don’t we have to
    stomach the rollercoaster ride of the market where bubbles
    burst, ineffecient “losers” are shed and the market
    re-emerges a leaner and more effecient animal than before.
    Your idea makes sense except by moderating what people can
    do (or borrow) you would also be moderating what they can
    achieve and ultimately stifle enterprise.

    And unless we are currently staring into a
    never-to-be-forgotten 20-year recession or something I don’t
    think we will ever settle for what we consider sub-par growth.

  11. Pete

    >In time the balance sheet plays tricks on the banks.

    The “chicken-and-egg” situation whereby borrowing inflates
    asset prices is so obvious to everyone, even those with no
    financial education at all, that I cannot believe that it
    is not also obvious to the people who run banks. The fact
    that they continue to behave in this bizarre way suggests
    that they find it a profitable way to behave.

    Boom and bust economics results in huge transfers of
    wealth, mostly from stupid people to smart people. As the
    banks and government are mostly run by fairly smart
    people, perhaps they’d prefer to stick with boom-bust
    rather than smooth things out?

  12. Laura

    I couldn’t help noticing in yesterday’s biz section that
    AIB is considering selling ALL its Irish property assets.
    Considering that AIB is the largest banker in Ireland with
    an enormous loan book, it certainly makes some suggestions
    about the market. It will be interesting to see if PTSB
    and BOI make similar moves.

    While there is a suggestion that property prices are
    stabilising my closest friend is currently trying to
    purchase a modest property in Cork. Far from it are
    property prices slowing! If anything they are escalating
    at a rate unseen since the heady rises from 1996 to 1998.
    She’s been looking, to give an example, at a modest 2 bed
    terrace in a small town nearly 20 miles outside Cork.
    Advertised at 200k, the price has now risen to 223k and the
    bidding is continuing! Its a house fairly new, but
    previously owned by an amateur landlord and so in shabby
    condition (apparently the carpets simply need to be ripped
    out). Yet the price of the house has “risen” by more than
    10% in less than a few weeks. Likewise in East Cork,
    houses selling at 160-200k last year are now priced (and
    probably selling at a higher end bid) of 240-285k – and
    higher. Far from it is the property bubble easing – if
    anything its hurdling upwards at an even rapid rate.

    Only the test of time will tell if this is sustainable. I
    read yesterday that Ireland’s demographics (based on birth
    and immigration) are “favourable” to continued growth for
    15 years. Surely this is based on a highly optimistic view
    of the world’s economy, not to mention Ireland’s economy?
    Nobody seems to mention that a large proportion of
    immigrants end up leaving the country. Not to mention the
    fact that a vocal minority are very hostile to them being
    here in the first place.

  13. Paul Rux, Ph.D.

    David, here in the Midwest of America the easy credit
    continues to cause sprawl. Sadly, many owners of these new
    mansions are “two paychecks from the pavement” because of
    adjustable home mortgages. The slightest hike of interest
    rates puts most of them at risk for losing everything.

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