Asset Price Booms Research Articles

Florida (Un)chained

Excessively easy bank credit – visible in unusually small credit risk spreads and rapid loan growth – is often posited as a root cause of unsustainable asset price booms. This paper considers whether an increase in bank risk tolerance drove high loan growth that coincided with Florida's land boom of the mid-1920s, the first Florida housing boom in which buyers from around the nation participated. Estimates suggest that an astounding 20 million lots were offered for sale in Florida at that time. Our detailed narrative and empirical evidence suggest that the facts do not require the assumption of increased risk appetite during the boom. We find that most Florida banks that failed were associated with the Manley-Anthony chain and did not exhibit increases in observable indicators of risk during the boom. Instead, their increases in risk mainly reflected hidden choices either to lend to bank insiders on a preferential basis or to fund other banks that were engaged in such risky and often fraudulent activities. Bank regulators seem to have been complicit in the hidden risk-taking. Even informed investors would have been left in the dark about the amount of risk that was growing in Florida.

Global Spillovers of Asset Price Booms: Who Benefits from the End of Privilege?

Global Spillovers of Asset Price Booms: Who Benefits from the End of Privilege?

Bank lending behavior and housing market booms: The Australian evidence

The emerging literature on bank lending during an asset price boom has focused on the U.S. economy before the GFC when the housing market peaked. Following this line of research, this paper studies the Australian economy with its unique banking industry and sustained housing market boom. Results from the single equation and the panel vector autoregression (PVAR) show evidence of crowding out of business loans towards housing loans in response to increased opportunities in strong housing markets, which in turn curtails business investment. In contrast to Chakraborty et al. (2018), such a crowding-out effect is evident only in the Big Four banks, which are dominant and less capital constrained lenders in the credit market. Further examination shows that regulatory advantage enjoyed by and the profit-seeking motives of the Big Four banks might underscore the findings. We do not find a significant crowding-out effect on consumer credit.

Asset Price Booms and Macroeconomic Policy: A Risk-Shifting Approach

This paper uses a risk-shifting model to analyze policy responses to asset price booms. We show risk shifting leads to inefficient asset and credit booms in which asset prices can exceed fundamentals. However, the inefficiencies associated with risk shifting arise independently of whether the asset is a bubble. Given evidence of risk shifting, policymakers may not need to determine if assets are bubbles to justify intervention. We then show that some of the main candidate interventions against asset booms have ambiguous welfare implications: tighter monetary policy can mitigate some inefficiencies but at a cost, while leverage restrictions may raise asset prices and lead to more leveraged speculation rather than less. Policy responses are more effective when they disproportionately discourage riskier investments. (JEL D82, E23, E32, E44, E52, G01, G12)

Booming house prices add to inflation concerns

▪ Rapid house price rises are feeding into a broader asset price boom that's the strongest in decades and also unusually synchronised across assets. This trend has potentially large macroeconomic effects. Recent asset booms haven't generally been inflationary, but the current one, alongside other upward pressures on prices, adds to the need for central bank vigilance. ▪ House prices are growing at over 10% y/y in many major economies, with real prices across the advanced economies climbing at the fastest pace since the peak of 2005. The housing surge is part of a broader asset boom encompassing stocks and commodities. US stocks already looked overvalued before the pandemic, but the current asset price surge is the biggest in decades and also unusually synchronised across assets. ▪ The asset price boom has potentially large impacts on spending. We forecast US household wealth will rise around 20% this year, a record pace, which could add about 2% to consumer spending. The impact on consumption could be boosted by a revival in home equity withdrawal visible in the US and UK. ▪ Rising asset prices could also be an indicator of inflation risks, especially in the context of loose monetary conditions and other upward pressures. The historical experience is mixed, with asset booms sometimes associated with high inflation but not consistently so. ▪ Well‐anchored inflation expectations cut the risk of asset inflation spilling over to price inflation, but loose monetary conditions could push asset prices even higher, risking an eventual sharp correction. For central banks, neither this outcome nor persistently higher inflation are attractive prospect.

Early warning of systemic risk in global banking: eigen-pair R number for financial contagion and market price-based methods

We analyse systemic risk in the core global banking system using a new network-based spectral eigen-pair method, which treats network failure as a dynamical system stability problem. This is compared with market price-based Systemic Risk Indexes (SRIs), viz. Marginal Expected Shortfall (MES), Delta Conditional Value-at-Risk (Delta-CoVaR), and Conditional Capital Shortfall Measure of Systemic Risk (SRISK) in a cross-border setting. Unlike paradoxical market price based risk measures, which underestimate risk during periods of asset price booms, the eigen-pair method based on bilateral balance sheet data gives early-warning of instability in terms of the tipping point that is analogous to the R number in epidemic models. For this regulatory capital thresholds are used. Furthermore, network centrality measures identify systemically important and vulnerable banking systems. Market price-based SRIs are contemporaneous with the crisis and they are found to covary with risk measures like VaR and betas.

Leaning against the Wind and Crisis Risk

Can central banks defuse rising stability risks in financial booms by leaning against the wind with higher interest rates? This paper studies the state-dependent effects of monetary policy on financial crisis risk. Based on the near-universe of advanced economy financial cycles since the nineteenth century, we show that discretionary leaning against the wind policies during credit and asset price booms are more likely to trigger crises than prevent them. (JEL E43, E44, E52, E58, F33)

Why a pandemic recession boosts asset prices

Economic recessions are traditionally associated with asset price declines, and recoveries with asset price booms. Standard asset pricing models make sense of this: during a recession, dividends are low and the marginal value of income is high, causing low asset prices. Here, I develop a simple model which shows that this is not true during a recession caused by consumption restrictions, such as those seen during the 2020 pandemic: the restrictions drive the marginal value of income down, and thereby drive asset prices up, to an extent that tends to overwhelm the effect of low dividends. This result holds even if investors misperceive the economic forces at work.

Divergent risk-attitudes and endogenous collateral constraints

Financial crises are anticipated by leverage build-up and asset price booms and followed by sharp de-leveraging and asset price burst. Leverage pro-cyclicality, debt margins counter-cyclicality and heightened asset price volatility are often hard to reconcile with credit frictions models, with and without occasionally binding constraints. We show that a model in which the anticipatory effects of occasionally binding collateral constraints interact with borrowers' time-varying risk-attitudes (modeled through gain-loss reference dependent utilities) and with borrowers/lenders risk-attitudes heterogeneity can explain those facts. Simulations through global methods show that the model can also match numerous statistics characterizing the asset price and leverage cycles.

Twin Crises: A Comparative Analysis of the Global Financial Crisis of 2007-09 and the Asian Financial Crisis of 1997-99

This paper presents a comparative analysis of the key causes and effects of The Asian Financial Crisis (AFC) of 1997-99 and the Global Financial Crisis (GFC) of 2007-09. Drawing on existing financial crisis scholarship, the author finds that weak institutions, speculative attacks and political corruption were accelerants of the AFC and GFC, but not root causes. The author finds evidence that, as with the Global Financial Crisis, the most important factors were (a) the rapid accumulation of credit and an asset price boom in the lead-up to a banking crisis, (b) a consequent sharp deterioration of asset values through a leverage downswing, (c) the impact of a leverage downswing on securities markets and financial institutions at systemically important junctures within under- and unregulated frontiers, and (d) credit and liquidity crunches that froze capital allocation. These patterns offer lessons about common themes across financial crises, and recommend several areas that may be the subject of continued research.

Financial Integration, Savings Gluts, and Asset Price Booms

AbstractCapital outflows after financial integration can lead to simultaneous increases in the national savings rate and asset prices of an economy with substantial financing costs. Under autarky, firms invest in risky capital while facing a borrowing constraint that creates a need for precautionary savings. Financial integration provides firms with access to foreign risk-free assets and results in two effects: a substitution effect, whereby firms divert some investments to foreign assets and cause capital outflows; and a wealth effect, whereby they grow richer in equilibrium and thus demand more domestic capital. Savings gluts and asset price booms occur when the wealth effect dominates.

Leaning Against the Wind and Crisis Risk

Can central banks defuse rising stability risks in financial booms by leaning against the wind with higher interest rates? This paper studies the state-dependent effects of monetary policy on financial crisis risk. Based on the near-universe of advanced economy financial cycles since the 19th century, we show that discretionary leaning against the wind policies during credit and asset price booms are more likely to trigger crises than prevent them.

A Bayesian Signals Approach for the Detection of Crises

In this paper, we consider the signals approach as an early-warning-system to detect crises. Crisis detection from a signals approach involves Type I and II errors which are handled through a utility function. We provide a Bayesian model and we test the effectiveness of the signals approach in three data sets: (1) Currency and banking crises for 76 currency and 26 banking crises in 15 developing and 5 industrial countries between 1970 and 1995, (2) costly asset price booms using quarterly data ranging from 1970 to 2007, and (3) public debt crises in Europe in 11 countries in the European Monetary Union from the introduction of the Euro until November 2011. The Bayesian model relies on a vector autoregression for indicator variables, and incorporates dynamic factors, time-varying weights in the latent composite indicator and special priors to avoid the proliferation of parameters. The Bayesian vector autoregressions are extended to a semi-parametric context to capture non-linearities. Our evidence reveals that our approach is successful as an early-warning mechanism after allowing for breaks and nonlinearities and, perhaps more importantly, the composite indicator is better represented as a flexible nonlinear function of the underlying indicators.

Does machine learning help us predict banking crises?

This paper compares the out-of-sample predictive performance of different early warning models for systemic banking crises using a sample of advanced economies covering the past 45 years. We compare a benchmark logit approach to several machine learning approaches recently proposed in the literature. We find that while machine learning methods often attain a very high in-sample fit, they are outperformed by the logit approach in recursive out-of-sample evaluations. This result is robust to the choice of performance metric, crisis definition, preference parameter, and sample length, as well as to using different sets of variables and data transformations. Thus, our paper suggests that further enhancements to machine learning early warning models are needed before they are able to offer a substantial value-added for predicting systemic banking crises. Conventional logit models appear to use the available information already fairly efficiently, and would for instance have been able to predict the 2007/2008 financial crisis out-of-sample for many countries. In line with economic intuition, these models identify credit expansions, asset price booms and external imbalances as key predictors of systemic banking crises.

Prudential Monetary Policy

Should monetary policy have a prudential dimension? That is, should policymakers raise interest rates to rein in financial excesses during a boom? We theoretically investigate this issue using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors' balance sheets. An alternative intuition is that PMP raises the interest rate to create room for monetary policy to react to negative asset price shocks. The policy is most effective when there is extensive speculation and leverage limits are neither too tight nor too slack. When shadow banks are present, PMP can still replicate the benefits of macroprudential policy, but PMP is less effective (like macroprudential policy) because shadow banks respond by increasing their leverage.

MONEY, CREDIT, HOUSE PRICES AND QUANTITATIVE EASING – THE WAVELET PERSPECTIVE FROM 1970 TO 2016

This paper investigates the relationship between money/credit growth and house price inflation for a sample of twelve developed countries. The novel application of the continuous wavelet transform showed significant but time-varying linkages between these two variables. During quantitative easing in the United States and the United Kingdom, growth of respectively broad money and bank credit was leading house price inflation for the 2-8 years cycle. In contrast to this, the Bank of Japan and the European Central Bank either did not assign a separate role to house prices in their reaction functions or the two central banks were not capable to significantly increase house prices by extending money/credit during the business cycle. The significant co-movements of financial variables and house prices around booming episodes warn us that a new asset price boom might appear within the length of a business cycle as a consequence of overly expansionary monetary policy. In the euro area, the significant, long run, and close to a one-for-one link between growth of M3 and house price inflation is an argument for the monetary pillar of the European Central Bank. The present study contributes significantly to the literature by introducing a novel application of a continuous wavelet transform to study the housing prices in relation to money, credit and quantitative easing. The article uses a long-term dataset covering a period of almost half a century to analyse their varying relationship in the short-run to the long-run and from the historical perspective.

Stress Testing Made Easy: No More US Banks Stumbling and Facing Public Embarrassment Due to the Federal Reserve’s Qualitative Objection

The worst two financial crises in human history were in some ways attributable to the US Federal Reserve’s misguided monetary policies. Many economists share the view that the Fed’s tight-money policy in the late 1920s caused a significant drop in the money stock (i.e. severe contraction) which triggered the 1929 stock market crash and the subsequent Great Depression – the worst financial catastrophe of the 20th century. Close to a century later, the Federal Reserve was on the scene again, this time economists argue that the Fed’s expansive monetary policy since the late 1990s created an easy-credit environment (global dollar glut) which induced banks to expand credit into sub-prime segment turning ordinary folks into avid buyers (i.e. asset-price boom). Consequently, the Fed’s policy errors along with unfolding contributing and driving forces led to the 2006 mortgage debacle in the U.S., subsequently an ordinary looking recession was turned into the inevitable 2008 global financial crisis (GFC) – the worst financial catastrophe of the 21st century. The Trump administration wants to reverse the bank regulation rules that were put in place following the GFC; last time, President Clinton repealed the Glass-Steagall Act of 1933 by signing into law the 1999 Gramm-Leach Bliley Act, which fostered the boom-and-bust of the dot.com and housing bubbles, and the eventual GFC. The crises in the new millennium have cost investors over $30 trillion and pushed millions of people into poverty. Stress testing, a simulation technique used by individual banks, supervisory community, and central banks to safeguard financial stability, has evolved to become a crisis-management tool. Stress testing is neither a standalone tool nor an early-warning mechanism, but it is indispensable in the macroeconomic toolkit when used as a complement not a supplement to other tools such as VaR. To ease up the rules of regulation that was put in place after a near financial meltdown in the U.S. would be a fatal mistake by the Trump administration, even if the goal is to favor US’ largest banks.

Prudential Monetary Policy

Should monetary policymakers raise interest rates during a boom to rein in financial excesses? We theoretically investigate this question using an aggregate demand model with asset price booms and financial speculation. In our model, monetary policy affects financial stability through its impact on asset prices. Our main result shows that, when macroprudential policy is imperfect, there are conditions under which small doses of prudential monetary policy (PMP) can provide financial stability benefits that are equivalent to tightening leverage limits. PMP reduces asset prices during the boom, which softens the asset price crash when the economy transitions into a recession. This mitigates the recession because higher asset prices support leveraged, high-valuation investors’ balance sheets. The policy is most effective when the recession is more likely and leverage limits are neither too tight nor too slack. With shadow banks, whether PMP “gets in all the cracks” or not depends on the constraints faced by shadow banks.

Private Debt Booms and the Real Economy: Do the Benefits Outweigh the Costs?

Probably not. Economic development coincides with rising private debt-to-GDP. This partly reflects the economic benefits of credit deepening, which facilitates a better allocation of savings towards productive investment. However, private debt booms, episodes of rapid expansion in private debt-to-GDP, systemically predict growth slowdowns that result in lower real GDP. Debt booms distort the economy by boosting demand instead of productive capacity and by fueling asset price booms. These booms leave in their wake private debt overhang, banking sector distress, and an overvalued real exchange rate. Private debt booms are thus distinct from credit deepening episodes, and the costs of these booms likely outweigh the benefits.

The Bank of Canada and Financial Stability: A New Mandate?,

In 2016, the Bank of Canada (BoC) and the government agreed to renew the 2 percent inflation target for five more years. The Bank’s own research concluded that it might be beneficial to show flexibility in responding to the build-up of financial imbalances. Recent history has shown that such conditions can produce asset-price booms that, once the inevitable bust occurs, may trigger a financial crisis. If financial imbalances are equated with greater risks to financial stability it is natural to ask whether this could conflict with the Bank’s mandate of targeting headline inflation with a plus or minus 1 percent tolerance range. We conclude that the Bank of Canada’s focus on price stability should not change. However, the Bank ought to be provided with greater latitude to become more forward-looking in highlighting potential threats, both domestic and foreign, to financial stability. We marshal historical and empirical evidence to make our case. A major impediment to burdening the BoC with additional responsibilities to maintain financial stability is that there is disagreement not only about when financial instability erupts, not to mention the form this instability can take, but also about its overall economic impact. Although calls to increase the burdens placed on central banks have become more widespread in recent years at the international level, policymakers also need to be made aware that such views are sometimes based on erroneous assumptions. These include: (i) All financial crises are the same. They are not. (ii) We know the size, timing and spillovers from financial crises. There is no one-size-fits-all response to financial crises. (iii) Financial stability policy is capable of being forward-looking. Unlike monetary policy, which has been forwardlooking for more than two decades, there is little evidence yet that the same is currently feasible to maintain future financial stability. Any renewal of the Bank of Canada’s inflation target, while explicitly acknowledging the Bank’s role as one of several agencies responsible for the maintenance of financial stability, should not confuse the public by adding the burden of meeting a goal it cannot reasonably achieve on its own. Unlike inflation, which inflationtargeting central banks have managed to control within tolerance ranges for more than two decades, financial stability requires a much wider set of tools. If the central bank were to become responsible for these tools, this would bring the institution dangerously close to making political-style decisions.