Prior to the Global Financial Crisis (GFC), central bankers tend to adopt the ostrich’s mentality to asset price bubbles. Alan Greenspan, the chief architect of this school of thought believes that central bankers should only target price stability and price inflation with their interest rate levers. Greenspan argued that since it is impossible to know when bubbles will burst, it is impossible to intervene at the right moment (we heard of another twist to Greenspan’s argument- one can never know whether it’s a bubble until it bursts).
What about Australia? As we reported in What should the RBA do?, the RBA, regardless of whether it believes asset price bubbles are dangerous or not, do not have the mandate to prick them,
The masses have not given the RBA the mandate to spoil the asset price inflation party. Although, Ian Macfarlane acknowledged that asset price bubbles can be very dangerous for the economy, his hands were tied. Elsewhere, Coalition opposition politicians were toeing the populist line by demanding that Glen Stevens (the current head of the RBA) be grilled more frequently in order to pressure him against hiking interest rates.
This ostrich mentality of central bankers is strongly criticised by the Bank for International Settlement (BIS). As we wrote before in Bank for International Settlements (BIS) warning on stimulus spendings, the BIS is the
… only international body that had correctly anticipated the global financial crisis (GFC) and warned of another great depression back in June 2007, when they released their 77th annual report (see Bank for International Settlements warns of another Great Depression).
The BIS is dubbed as the central banker of central banks. Its chief-economist, William White, whom we believe is from the Austrian School
Greenspan and White stood at opposing sides. It seemed that Greenspan’s views held sway among the central bankers. He was dubbed as the “Maestro” and was celebrated as the world’s greatest central banker. No one in the world of central banking dared to openly criticised Greenspan, except for William White of the BIS. Since Greenspan was a member of the board of directors of the BIS, he was technically White’s superior. Greenspan had the upper hand until…
… until the GFC erupted and the financial world order came close to collapse in 2008. And so, Greenspan is dis-credited today. White’s theory gained ascendency. As this article reported,
The group of the 20 most important industrialized and emerging nations, which is now left with the task of cleaning up the wreckage of the crisis, apparently faces less academic problems. At the London G-20 summit in April, the group decided to promote a crisis-prevention model based on White’s theories.
They want to introduce what might be called his hoarding model, which calls for banks to build up reserves in good times so that they can be more flexible in bad times. The central banks, according to White, must actively counteract bubbles and exert stronger control over the financial industry, including hedge funds and insurance companies.
As an adviser to German Chancellor Angela Merkel’s group of experts, White helped to shape the basic tenets of the new order. And the 79th annual report of the BIS, published in Basel last week, also reads like pure White. It lists, as the causes of the crisis, extensive global imbalances, a lengthy phase of low real interest rates, distorted incentive systems and underestimated risks. In addition to improved regulation, the BIS argues that “asset prices and credit growth must be more directly integrated into monetary policy frameworks.”
What does this imply for investors?
It means that any investments and investment strategy that depends on ever rising asset prices to work will no longer work in this new global financial order. To put it bluntly, in this new financial order, the Reserve Bank of Australia (RBA) will not let property prices balloon as it did over the past 10 years. As the RBA governor Glenn Stevens said (as reported in this Bloomberg article),
Australian central bank Governor Glenn Stevens said policy makers must be cautious about cutting interest rates too far because that may encourage some borrowers into debt they can?t afford.
?It is the intention of current monetary policy settings to lower debt-servicing costs, assist efforts to reduce leverage and support demand,? Stevens told a conference in Townsville, Australia, today. ?It would be counterproductive, though, if further reductions in interest rates induced a large number of marginal borrowers into debts they could service only at unusually low interest rates.?
This is just an example of a sea-change in thinking among central bankers.
