Wednesday, November 25, 2009

Heed the danger of asset bubbles

By Robert Zoellick
Published: November 24 2009 20:03 | Last updated: November 24 2009 20:03
As the world begins to recover from the worst downturn since the Great Depression, the conventional wisdom is that we have employed lessons of the past effectively: a flood of money; a dose of fiscal stimulus; and an avoidance of the worst trade protectionism. We even have Ben Bernanke, a scholar of the Depression, at the helm of the US Federal Reserve. So what could we be missing?
The old playbook may have new, unintended consequences. Last year, when governments faced financial markets paralysed by possible failure of counterparties, they used the tools they had, even if an imperfect fit. To keep credit flowing, central banks opened the money spigots. When traditional monetary tools were insufficient, they invented new ones to buy or lend against assets. And it worked.
Of course, governments knew these dramatic actions would have consequences. Central banks have been watching carefully for early signs of the traditional danger – inflation. Yet in a new era of global competition, companies are unlikely to have the pricing power that led to “demand pull” inflation in decades past; nor are unions likely to be able to make wage demands that contributed to “cost-push” stagflation. Walmart and the developing world’s labour force have changed the paradigm.
Yet the revival of John Maynard Keynes should not lead us to ignore Milton Friedman: where will all that money go? For a hint of the future, look to Asia, where a new risk is emerging: asset bubbles.
Asia is now leading the world economy with increases in industrial production and trade, partly reflecting the growth in China and India. This welcome economic upswing is accompanied by rising equity and property prices. House prices in China jumped in October by the biggest amount in 14 months, with a recent auction in Shanghai attracting record bids to a commercial property that drew none last year. Elsewhere in Asia, equity markets have surged and property prices are on the rise, notably in Hong Kong and Singapore. Gold is rising and the prices of other commodities are likely to rise too. The combination of loose money, volatile commodity markets and poor harvests – such as occurred recently in India – could make 2010 another dangerous year for food prices in poor countries. Asset bubbles could be the next fragility as the world recovers, threatening again to destroy livelihoods and trap millions more in poverty.
Unfortunately, the chapters in the history books about how to deal with asset bubbles usually precede tales of woe. Asset bubbles can be more insidious than traditional product inflation, because they seem to be a sign of health: higher values lift the real economy, which in turn can send the bubbles higher. Jaw-boning irrational exuberance has not worked well against asset or product price inflation. Waiting for bubbles to burst and then cleaning up the aftermath is now a new lesson of what not to do. But tightening interest rates too abruptly – especially where recoveries are weak, such as in the US and Europe – could trigger another downturn.
Australia, with its ties to the Asian economies, has already raised interest rates. Asian countries, which traditionally follow the US Fed’s monetary policy, will be under pressure to follow. But raising rates while the Fed keeps its rates close to zero would cause Asian currencies to appreciate. This would make their exports more expensive and decrease overseas sales, hurting recoveries based on exports. More­over, there is competition from China. The renminbi is tied to a declining US dollar that makes Chinese goods cheaper to buy than those of Asian rivals.
Some policymakers in Asia are testing alternative approaches. In Singapore, the 16 per cent surge in property prices during the third quarter of this year led the authorities to release more land for development and to take steps to stop borrowers from deferring payments. Other more focused measures include setting targets for the overall rate of growth of bank credit, imposing caps on the share of bank lending for real estate and portfolio investments, or higher capital requirements for riskier lenders. In developed countries, where central banks want to keep rates low, regulators should be considering supplementary tools such as raising margin requirements on stock, bond and futures transactions, or raising down-payment requirements on commercial or speculative real estate deals.
It would also help if North America and Europe took a closer look at the agenda that Australia and many Asian countries are starting to pursue. To build confidence and opportunity for the private sector, the Asia-Pacific countries are advancing structural reforms – including in service sectors – to boost productivity and potential growth. These reforms will help them to compete even if their currencies appreciate.
Perhaps the primary lesson from history is for countries to co-operate in making assessments that distinguish their situations, avoiding one-size-fits-all “exit strategies”, and cautioning against currency or trade protectionism. Debates about new financial regulatory structures should not distract governments from using tools they have to counter these emerging risks. These will be the challenges for the Group of 20 nations in 2010. The G20 had better put asset price bubbles and new growth strategies on its agenda. Otherwise, the solutions of 2008-09 could plant the seeds of trouble in 2010 and beyond.

The writer is president of the World Bank Group

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