It’s Not When to Exit, But Who

By: Barry Eichengreen

Investors are getting antsy about the timing of central banks’ exit from their accommodating monetary policies and extraordinary asset-purchase programs. Increasingly one hears commentary warning of inflation, although with unemployment still rising and consumer demand still falling, it is hard to imagine much near-term inflation in the United States, Europe or Japan. 

 

Commentators are on firmer ground when they warn that dangerous asset bubbles are developing in emerging Asia and in China in particular.  And it is not only independent critics: the World Bank, in its recent semi-annual report on East Asia, warned darkly of unsustainable asset-market conditions.  Asset prices are frothy.  Property prices are booming, especially in the big cities.  All this is alarmingly reminiscent of the United States in 2006.

 

The mechanism inflating these bubbles is exceptionally accommodating monetary policies.  Low interest rates in the advanced countries provide an incentive to borrow there and invest in higher-yielding assets in emerging markets.  Everyone realizes that the dollar will have to fall to enable the U.S. to export more, since American households will be consuming less.  But this means that the expected cost of borrowing dollars is effectively negative for investors concerned with non-dollar returns.  It creates an irresistible temptation to invest in anything Asian that promises even remotely positive returns.  Nouriel Roubini, always one with a phrase, calls this “the mother of all carry trades.”

 

It is as if we have learned nothing from the experience of the last three years.  Central banks are still blowing bubbles.  Focusing narrowly on inflation, they continue to ignore their responsibility for financial stability.

 

These worries are creating strong pressure for central banks to turn off the tap.  Australia and Norway have already moved in this direction.  There is growing pressure for others to follow.  Prognosticators are desperately parsing the Fed’s recent policy statements for evidence that it is prepared to head for the exit.  Failing to find it, they subject the American central bank to a barrage of criticism.  They refer disparagingly to “Bubble-Blowing Ben.”

 

But while the diagnosis is right – Asia’s bubbles now pose a serious risk to financial stability – the prescription is wrong.  Leaning against them is a task for Asia’s central banks and regulators, not for the Fed or the ECB.  With U.S. and European unemployment continuing to rise, accommodative monetary policies remain appropriate for the Fed and the ECB.  With financial markets still in the recovery ward, both central banks are right to pause before unwinding their accommodating policies.  And when they begin, they should do so incrementally.  They should proceed with delicacy.  Above all, they should realize that starting now for the exit would be premature.

 

But nothing prevents emerging Asian central banks from acting.  US monetary conditions are not appropriate to their circumstances.  Their economies are growing robustly.  They are the ones with bubble trouble.  They can and should tighten now.

 

Yes, doing so will create problems.  In particular, tightening while the Fed remains on hold will mean that emerging Asian currencies will appreciate against the dollar.  This will be uncomfortable for a set of economies accustomed to export-led growth and to the security of dollar pegs.  But if the price of those dollar pegs is an asset bubble that sets the stage for a disruptive crash – one that does serious damage to banks and corporations with significant exposures to the property market – then that price is no longer worth paying. 

 

There is also the worry that if Asian central banks tighten, signaling that they are prepared to see their exchange rates rise, they will just attract more capital inflows from speculators betting that their currencies will strengthen.  Here regulators need to step in to prevent inflows from fueling more asset-market excesses.  In countries like China where they control the allocation of credit directly, regulators need to impose stricter ceilings on bank lending.  They need to tighten collateral requirements in property markets.  More governments might also consider taxes on financial capital inflows like those imposed in October by Brazil.

 

The danger posed by Asia’s financial bubbles is real.  But it is important to take the right steps to combat it.  This is appropriately a task for emerging market central banks, not for the Fed or the ECB.  It is not helpful to amputate the patient’s right foot when it is the left foot that is infected.

  

           

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.

 

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