Osborne on credit cycles

George Osborne is showing commendable signs of starting to think about macroeconomics. However, I have several problems with his recent speech. He says:

The new economic challenge of our time, then, is to tame the credit cycle without damaging the dynamic financial sector.

And he suggests we consider using counter-cyclical capital requirements upon banks to limit their lending in good times:

financial crises are born during the financial booms that precede them - the only way to prevent the bad times is to stop the good times getting out of control.

I’ve got five issues here.
1. Is the “credit cycle” due more to supply forces - banks are readier to end in good times - or demand forces, with banks merely passively responding to changes in consumer and business confidence?
The question matters, because fluctuations in confidence can be justified. Imagine a technical breakthrough raises likely future productivity growth. It would be entirely rational for companies and consumers to borrow more in rational anticipation of better times. If you impose tougher capital controls in these conditions, you’ll just destroy sustainable and efficient economic activity.
2. Are counter-cyclical capital requirements feasible? Do governments really want to anger voters by denying them credit? And do they want to say: “the current good times aren’t the result of our good macroeconomic management - they are just a bubble”?
And even if one government does impose them, they’d be useless in just one country, as lending would merely shift offshore.
3. Is borrowing really unsustainable? Osborne says:

We have warned for several years that the boom in household indebtedness was unsustainable - as I said two years ago "an economy built on debt is living on borrowed time."

But is there a problem here? Put yourself in my position. In a couple of week’s time, my credit card bills will look horrible, as I’m buying a car and lots of furniture for my Oakham abode. And because I’ll not (I hope) repeat these purchases, my spending will crash later. In this sense, my debt and spending are unsustainable. But this is no problem, as I’ve got cash in the bank to pay these debts.
And the aggregate consumer is in a similar position to me. Households’ bank deposits are equivalent to over 12 months’ disposable income, and are six times as high as their non-mortgage debt (table A4.1 here). And individual insolvencies have fallen recently, suggesting over-indebtedness isn’t a serious aggregate problem.
The notion that households in general recklessly over-borrow in good times - a notion Osborne comes too close to supporting - owes more to a prejudiced contempt for individuals’ rationality than to the data.
4. Are asset price “bubbles” really destabilizing? The remarkable thing about the bursting of the tech bubble in 2000-01 was how little impact it had - it caused only the mildest recession in the US, and none at all in the UK.
Even the allegedly gloomy IMF believes the same could be true of the current credit crunch. It expects the global economy to grow by 3.7% this year. And even its forecast for the UK, of 1.6% growth, is only around a percentage point below our trend growth rate. This is hardly a catastrophe. And it might be too pessimistic. Latest data show that manufacturing and retail sales were stronger than expected in February, suggesting the economy is starting 2008 from a stronger base than thought.
This shouldn't be surprising. House prices are not net wealth, so a fall in them shouldn't greatly depress activity.
5. Is Osborne - like Brown and Darling - guilty of statistical fetishism here? What matters is not the volatility of GDP - which is small, even if the gloomiest forecasts are right - but the uncertainty faced by real individuals. People matter; statistical aggregates don’t. The task for a Chancellor, surely, should be to find ways of protecting people from risks they cannot control without overly reducing incentives. This is not so much a task for macroeconomic policy - even stable GDP growth can be consistent with massive insecurity for real individuals - as for the microeconomics of designing a welfare state or private insurance markets. 

Comments

[Jack]

What ever happened to the global savings glut? Hard to use banks as a barrier against that.

How do countercyclical capital requirements work on off balance sheet SIVs and unregulated hedge funds?

In good times banks pile on capital and are not constrained by it so intervention would have to be brutal if it is to have any effect.

So, to implement such an idea, politicians will have to know what stage of the cycle they are at, be prepared to take steps that are unpopular and in the short term actually damaging, use measures more extreme than they are used to and to radically extend the range of regulation.

Apart from that it's a great idea. Do you know who thought of it originally? Are there numbers?

[Bob B]

Many thanks.

For starters, I think we should exonerate George Osborne from belatedly leading a misguided charge here.

Roger Bootle, of Capital Economics, was trying to worry us about the house price bubble and its likely downstream consequences five years ago in his book: Money for Nothing (2003):
http://news.bbc.co.uk/1/hi/business/4314073.stm

Besides Roger Bootle, I've only just learned of a book by Charles Goodhart, which I've yet to get and read: House Prices and the Macroeconomy: Implications for Banking and Price Stability (OUP, 2006)

Gordon Brown seemed to be almost bragging about the bubble a few days back and, of course, it has to be admitted that the bubble is popular with existing house owners. In a BBC interview, he said: "We've seen house prices rise by about 180% over the last 10 years and they have risen by about 18% over the last three years, so a 2.5% fall is something that is containable."

We can comprehend the electoral consequences of a feel-good factor but surely, he must have realised that a rise of 180% in average house prices over the last 10 years means serious challenges for first-time house buyers, especially for public service employees, and especially with the miserable record of house building during New Labour governance:
http://www.communities.gov.uk/news/corporate/696795

And GB must surely have been briefed that several "informed" commentators have been saying for years that houses in Britain are overvalued by about 20% rising to 30%. He could have seen from the latest chart in The Economist (3 April): High-rise Living, that the house-price bubble in America is modest compared with the bubble here.

Btw I'm not persuaded by the comparison with the bursting of the dot.com bubble of 2000/1 and its light consequences. After all, many millions more own houses than owned dot.com equity and about half home-owners have outstanding mortgages.

[Bob B]

[continued]

With the scale of growing consumer indebtedness, I'll grant there is a problem of deciding precisely the moment when enough is enough but, as with many macroeconomic stability issues, the appropriate policy is more a case of "leaning against the wind" for reasons of prudence. The media were reporting that outstanding consumer debt had reached £1 trillion four years ago:
http://news.bbc.co.uk/1/hi/business/3935671.stm

Even Alistair Darling, as Chancellor, was last year urging British banks to "take a more cautious approach to lending":
http://news.bbc.co.uk/1/hi/business/6992450.stm

It doesn't take much nous to appreciate that the proliferation of 100% and 125% mortgages are likely to have advesre consequences downstream.

The big question is what, if anything, is the appropriate policy response to excessive and imprudent bank lending?

[Bob B]

Yet another reason why GB can't dodge the blame for fuelling the UK credit boom and an additional boost to the house price bubble.

In December 2003, the government set a new inflation target for the Bank of England when the Monetary Policy Committee makes decisions about setting interest rates:

"From May 1997 the target was 2 ½% for RPIX inflation. But in December the Chancellor gave the Monetary Policy Committee a new target for inflation. It is 2% as measured by the Consumer Prices Index or CPI, formerly known as the Harmonised Index of Consumer Prices."
http://www.bankofengland.co.uk/publications/speeches/2004/speech211.pdf

The consequence of that shift in the measures of inflation was that the two measures, the CPI and RPI, diverged thereafter according to the ONS:
http://www.statistics.gov.uk/cci/nugget.asp?ID=19

By February 2008, the annual rate of inflation by the CPI was running at 2.5%, compared with the old RPIX (Retail Prices Minus Mortgage Interest) at 3.7%. Had the old inflation target applied then interest rates would be significantly higher than they are now.

[tolkein]

I'd be interested to see if the recent behaviour by banks and non bank mortgage lenders will have a real impact on their Basel 2 capital requirements. One of the matters to be considered is pro-cyclicality - the tendency of banks to ease lending criteria in a boom and then tighten them in a recession. Banks are supposed to be able to demonstrate they have controls in place to avoid, or mitigate the effects of, procyclicality.

Recent events have demonstrated just how much reliance one should place on banks controls or intentions. I hope the FSA will mark their cards accordingly when reviewing the banks' Basel 2 applications.

It might be nice to read something in the press on this and other capital and risk related issues.

[Bob B]

The headline report in Thursday's FT includes this:

"The Institute of International Finance . . representing more than 375 of the world's largest financial companies acknowledged 'major points of weakness in business practices', including bankers' pay and management of risk."

Banks seem acutely anxious about the possibility of unwelcome new regulations to prevent a repetition of the present looming crisis in the credit cycle. It seems to be widely accepted now that prevailing performance pay schemes which reward bank staff for taking successful investment or trading decisions but impose no personal penalties for unsuccessful decisions or losses are bound to create an upward bias favouring risk regardless of eventual downstream consequences.

Of course, paying staff bonuses for signing up 100% and 125% mortgages looked altogether more sensible if house price inflation was set to continue indefinitely and there were no concerted signs from government ministers of wanting to rein it back until very recently.

There were warnings enough years ago from independent, informed commentators that the ratio of average house prices to average earnings was increasingly unsustainable but ministers with responsibility for housing took no action. I suspect the calculation was that booming house prices were good for New Labour's re-election prospects in 2005 and then came the hiatus over when Blair was to step down.

[Bob B]

News update:

"April 10 (Bloomberg) -- UK banks asked to increase sharply their borrowing facilities at the Bank of England yesterday over concern the current instability may leave them short of cash, the Financial Times reported.

"Banks have asked to be able to keep total reserves of 23.54 billion pounds on deposit at the central bank, up from the almost 20 billion pounds on deposit yesterday.

"Banks can borrow from the deposit if interbank lending is too expensive, the FT said."
http://www.bloomberg.com/apps/news?pid=20601102&sid=aY.RuOR9c33w&refer=uk

[Bob B]

New update 2:

See the time series graph of the ratio of house prices to average earnings in: The Bubble Bursts, in latest issue of The Economist out today:
http://www.economist.com/world/britain/displaystory.cfm?story_id=11024646

The government isn't in any position to deny that, from years back, the housing market was predictably heading into an unsustainable boom.