Hold tight, the central banks have no plan
By Wolfgang Munchau
Published: December 16 2007 16:03 | Last updated: December 17 2007 05:09
This has been the year when many deeply held beliefs have been challenged. One such belief was that central banks have the toolkit to sort out any conceivable economic or financial crisis.
Last week’s co-ordinated liquidity action by five central banks taught us that this is not the case. The idea was that a co-ordinated response would reassure the markets, but it had the opposite effect. It turned out that market participants are not infinitely stupid. They know by now that this is not a liquidity crisis at its core. If it had been, it would be over by now.
It is a fully fledged solvency crisis that has arisen because two giant and interlinked bubbles burst simultaneously – one in property, one in credit – leaving banks and investors on the brink of bankruptcy, some hanging on by their fingertips. Yet there is nothing the central banks are offering at this stage to alleviate a solvency crisis.
So the message from last week is that central banks have no game plan. Expect continued stress in financial markets for most of next year and possibly beyond. Expect also further declines in property prices in the US and the UK and spill-overs to the real economy.
As the European Central Bank correctly noted in last week’s financial stability report, the crisis is not going to be over until and unless there is a turnround in the property sector. But we are not going to see this for quite some time, not even in the US where the property market downturn began in 2006. In the UK, property prices have only recently started to fall.
I looked at the Nationwide house price index for the UK, which goes back to the early 1950s. After adjusting for inflation, the result is a line with two interesting characteristics. The first is that there is a surprisingly stable linear trend, with only a moderate upward shift. Real prices go up over time but not by much, and any deviations from the line are followed by a return to trend. The second is that past bubbles were relatively symmetric – both in extent and in time.
In the UK the latest upward movement has lasted 10 years and on my calculation prices started to rise above the trend line somewhere between 2000 and 2002. That would suggest that the downturn phase is going to last as long – possibly longer since downward moves often undershoot the trend line. Unless there has been some structural shift, there is going to be one of the most serious housing downturns ever.
Homeowners and mortgage lenders are always clinging to the hope that there may have been a structural shift. But even then, it is not at all clear whether such a shift would necessarily raise the position or the slope of the trend line. For example, an increase in housing supply or some regulatory restriction on credit may well lower it.
In an environment in which central banks target a low rate of inflation, the lion’s share of the adjustment will have to come from falling nominal house prices. That was different in the 1970s, when high inflation took care of the real price adjustment. But an inflation-targeting central bank cannot allow that to happen.
This raises the question of whether central banks, or governments, should consider raising their inflation targets. That would be a huge mistake, in my view, but I expect such a debate to hit us next year. Higher inflation would make it easier for indebted mortgage holders to cope with a multi-annual fall in real house prices.
Here is the basic arithmetic. Let us assume that the housing downturn is going to last eight years. A 2 per cent annual inflation rate – the target of many central banks today – adds up to 17 per cent inflation for the entire period; and a 4 per cent annual rate adds up to 37 per cent. So if UK house prices have to fall 40 per cent in real terms – which is not exaggerated given the extent of the bubble – an annual inflation rate of about 4 per cent would take care of the problem. Nominal houses prices would then not have to fall.
This is an experiment I would dearly love to watch, though preferably from outer space. A hypothetical increase in inflation targets would, I think, turn the current episode of turmoil into an uncontrolled financial crisis. Bonds would become the next asset class to crash and we could also expect violent adjustments in global exchange rates.
I suspect that central banks would dearly love to choose the semi-soft option – to allow a temporary overshoot in inflation targets and pray that people do not raise their inflation expectations. But that option has already been over-stretched, given that inflation expectations are already rising everywhere.
The bottom line is that inflation-targeting central banks will end up doing little more than swamp the financial markets with liquidity, and defend themselves against accusations that they had anything to do with this mess.