UBS COMMENT
BY COSTA VAYENAS
In 1997, after hiking interest rates several times and watching the US equity market reach new high after new high in what he famously termed a bout of “irrational exuberance,” former Fed Chairman Alan Greenspan finally threw in the towel. As he explained in his memoirs, published ten years later: “In effect, investors were teaching the Fed a lesson. You can’t tell when a market is overvalued, and you can’t fight market forces.” This was a reversal from the old Wall Street adage, “Don’t fight the Fed.” Greenspan’s admission of defeat was revealing: It underlined how firmly the belief in the righteousness of market forces was anchored among central bankers.
Or was it actually the threat of repeating Japan's experience in the early 1990s that made the Fed reluctant to curb financial excesses? Trying to deflate the immense equity and housing bubble that it helped inflate in the late 1980s, the Bank of Japan overdid its restrictive measures and did not act quickly enough to reverse monetary policy once the air was out of the bubble. This led to decades of deflationary stagnation in Japan, proving in hindsight that dealing with asset bubbles is not an easy task.
Whether it was denial, like current Fed Chairman Ben Bernanke’s now famous quote from 2005 (“US house prices largely reflect strong economic fundamentals.”) or an admission of powerlessness like the one given by Greenspan in a 2002 speech (“[…] it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity – the very outcome we would be seeking to avoid."), the Fed’s recent track record of dealing with bubbles has been rather dismal.
Moreover, it now seems that even the Fed, or at least Chairman Bernanke, refuses to accept any responsibility for having fueled the US housing bubble with excessively low interest rates. In a recent speech reviewing the housing bubble in the making, Bernanke concluded: “[…] monetary policy during that period – though certainly accommodative – does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives.”
In this context, the latest action out of China is encouraging. On 12 January, the People’s Bank of China decided to hike bank reserve requirements. This was seen as a first step toward a more restrictive monetary policy. Obviously, you can argue that it was first and foremost an attempt to cool the economy, which is now running at a growth rate of almost 11%, and tamp down on inflation, which has accelerated from half a percent to almost two percent within the past month.
In reality, however, the first objective of this measure, which was accompanied by a clear warning to different Chinese banks to control their lending activity and to watch for risks associated with the property sector, was to calm down the current real estate frenzy.
Is there a real estate bubble in China? The case is not yet very clear. Some prime real estate markets like Shanghai, Beijing and Shenzhen have seen a doubling of their prices over the last year. Despite this, prices have not surged in second-tier cities, and overall Chinese real estate prices have increased by only slightly more than 8% per year. Also, in terms of housing affordability, the valuation of Chinese real estate does not look extreme.
What prompted the People’s Bank of China to embark on a more restrictive policy was the tremendous lending growth observed in the first three weeks of 2010, which equaled what was seen in all of January 2009. Instead of guessing whether or not their housing market is in an actual bubble, the Chinese have decided to clamp down on the sort of activity that could potentially inflate a bubble in the first place.
There is definitively a lesson here for the Fed. In 2003-2006, the Fed was also confronted with a large increase in debt held by US households of roughly 10% a year. However, instead of worrying, the Fed saw this as an opportunity. To quote Greenspan in a 2005 speech: “Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.” Where such an analysis ultimately led is now well known.
Costa Vayenas is Head of Emerging Markets at UBS Wealth Management Research.
