Saturday, 9 May 2015

The Australian house price bubble.

According to a Financial Times article day before yesterday by Jamie Smyth, Australia has a problem. Title of the article is “Australia house price boom poses policy-making dilemma”.

The alleged dilemma is that house prices there are rising fast, which means an interest rate rise would be appropriate. But government wants to cut interest rates so as to impart stimulus. Oooh la la. What do do?

Well as the Nobel laureate economist Jan Tinbergen pointed out, it’s not too clever using one policy instrument to influence two or more policy objectives. You’re guaranteed at some point to get the above sort of dilemma.

In short, if fiscal policy (maybe plus QE) is used to boost demand, and interest rate rises are used to control asset price bubbles the problem is ameliorated.

Fiscal stimulus plus QE equals “print money and spend it, and/or cut taxes”. That puts more money into private sector pockets. But if anyone wants to use their new found wealth to pay interest on a loan to buy a house, they’ll find that relatively poor value for money (assuming interest rates are raised) compared to spending the money on consumption items (clothes, holidays, laptops etc).

That does not solve PART of the problem, namely foreigners buying houses in the relevant country with funds raised OUTSIDE that country. But it does cut demand for houses coming from citizens of the country with funds borrowed from other citizens.

Do asset price bubbles matter?

Of course we’re better off without asset price bubbles, but do they really matter? One of the biggest causes for concern is the possibility of a series of banks collapsing as a result of bubbles deflating, followed by years of recession and excess unemployment. Indeed that was one of the main causes the the banking crises around seven years ago.

But there’s a very simple solution to that: raise bank capital to the level where a big decline in asset prices doesn’t cause banks to go insolvent. Indeed that policy is part and parcel of full reserve banking: most versions of full reserve involve a 100% capital ratio which means that bank insolvency is almost impossible.

And as to the idea that very high capital ratios would increase bank funding costs, that’s not true assuming the Modigliani Miller theory is correct. And even if there is a slight increase in bank funding costs, that will in part be down to the removal of bank subsidies. Bank subsidies are INHERENT to the existing bank system.

That is, Too Big to Fail subsidies have not gone away, plus in some countries (e.g. the UK) all deposits are guaranteed gratis the taxpayer. In contrast in the US, small banks are protected by the self-funding FDIC, but big banks effectively rely on taxpayers. So the rise in bank funding costs attributable to the above removal of subsidies is wholly justified – though of course banksters will do their best to persuade politicians that that rise in bank funding costs is UNDESIRABLE. The “persuasion” is of course often enhanced by wads of cash in brown envelopes – or perhaps I should use a more polite phrase like “contributions to election expenses”.

Incidentally, the above “fiscal stimulus followed by QE” (aka “print money and spend it or cut taxes”) policy is part of the version of full reserve system advocated by Positive Money, Prof Richard Werner and the New Economics Foundation. The latter “print” policy is also approved of in Modern Monetary Theory circles.

Funds raised outside Australia.

Assuming the main problem with bubbles is the resulting possible bank collapses, then funds raised outside Australia are not a big problem for Australia. Of course any collapses will impinge on Australia to a finite extent. But basically if some bank OUTSIDE Australia goes bust, then Aussies can go down to the nearest bar, drink a few beers and have a laugh about it.

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