The banking crisis that didn’t happen

Saturos sent me a paper from Hyun Song Shin of the RBA:

It is not inevitable that the bursting of a property bubble undermines the financial system as a whole. The experience in Hong Kong following the bursting of the housing bubble in 1997 is a case in point. Residential property prices declined by around 70 per cent in Hong Kong between 1997 and 2004, but there was no banking crisis. There are important lessons to be learned from the Hong Kong experience. Loan-to-value ratios were generally very low in Hong Kong. Also, households continued to service their debt, even though the value of their houses fell far short of their mortgage obligations, pointing to the importance of the bankruptcy regime in place. If the borrower can declare bankruptcy, return the keys, and walk away, then it is the banking sector that will end up holding the depreciating property stock. It is unclear how far Hong Kong’s experience can be extrapolated to the US, Australia, Spain and the many other countries that have experienced residential property booms. Loan-to-value ratios and bankruptcy rules may differ substantially from those in place in Hong Kong.

Australia; an island of sanity in a world gone mad.  [Correction:  The paper was a RBA paper, but Shin is a Princeton University professor.]

PS.  Bob Murphy was gracious enough to send me a link showing that this blog ranks 27th among all Austrian blogs, beating Murphy who came in 34th.  In the future I expect Greg Ransom to meekly defer to my superior expertise on all matters Austrian.

PPS.  In a recent comment section there was a long debate about my claim that the 1933 dollar devaluation was inflationary.  The cost of living index (from the NBER) I am most familiar with showed a 10.6% increase between March 1933 and March 1934.  Most economic historians use the WPI, which rose by 22% in 12 months.  Some pointed to the CPI, which only increased by a bit over 5%, but that index was not reliable prior to WWII.  It shows no inflation from March to May 1933, which is absurd.  The news media was full of stories of soaring prices during the spring of 1933.  The Keynesian model predicts that prices should be falling during a period of 25% unemployment, especially given that inflation expectations were generally near zero back in those days; even the boom of 1927-29 was deflationary.  The only explanation for the sudden turnaround after March 1933, from rapid deflation to substantial inflation, is monetary policy.  And the Keynesian model is false; booms don’t cause inflation.  Monetary policy directly impacts NGDP, and that causes both higher RGDP and higher prices.



12 Responses to “The banking crisis that didn’t happen”

  1. Gravatar of david david
    8. August 2012 at 19:29

    Didn’t the Hong Kong Monetary Authority sense a bubble coming and oblige banks to a lower LTV ratio?

    The bankruptcy rule bit might require more elaboration. The extent to which the bank retains its solvency is exactly the extent to which households become insolvent, yes…?

  2. Gravatar of Dan S Dan S
    8. August 2012 at 19:52

    “Australia; an island of sanity in a world gone mad.”

    Makes me think of the movie “On the Beach,” where Australia is the only habitable place left in the world after a nuclear war.

  3. Gravatar of Greg C Greg C
    8. August 2012 at 21:15

    Hyun Song Shin is not “of the RBA.” He’s an Economics Prof at Princeton. He does research in awesomeness! Check out his work at Australia may indeed be a island of sanity in a world gone mad (I have some doubts), but the US is still quite good at hiring the best talent that the world offers.

  4. Gravatar of Ari Tai Ari Tai
    8. August 2012 at 21:19

    Australian banking has other challenges (large equipment loans to growing agribusiness struggling with bad weather losses), but “jingle mail” is not one of them (U.S. and Britain believe the bank assumes all loan risk irrespective of loan contract – unlike Australia – and Canada). If you speculate with a bank’s money and can’t repay, the judges treat you harshly. Your ordered to sell off all excess – including extra cars, furniture, take your children out of their private schools, forgo private health insurance, etc. The typical mortgage portfolio has a few notes in trouble – but those are true tragedies where the asset was a starter home with better than average LTV so the bank can extend generous terms and be seen as a good citizen – rather than a vulture.

  5. Gravatar of Saturos Saturos
    8. August 2012 at 21:22

    Monetary policy works by manipulating asset prices, especially long-term interest
    rates. Although a central bank generally directly controls only the overnight interest
    rate, its communication policy serves to guide the market’s expectations into doing
    its bidding. By moulding market expectations, the central bank can manipulate
    long-term interest rates, and thereby affect mortgage rates, corporate lending rates
    and other prices that have a direct impact on the economy.

    That sounds good, escpecially if you take “prices” broadly enough, and also the suggested transmission mechanism (Modigliani as well as Tobin/interest rate effects). But then he says:

    The wider consequences
    of monetary policy for the fi nancial system as a whole receive less weight in
    central bank pronouncements on monetary policy.


    When balance sheet
    changes affect asset prices, and asset-price changes affect balance sheets, the loop thus created can generate amplifi ed responses to an easing of monetary policy
    that cannot easily be unwound without exacting large economic costs.

    A sentence like: “a Tinbergen-style allocation of instruments to goals
    is envisaged where the goal of monetary policy is to ensure price stability, and
    supervisory/prudential policy is aimed at fi nancial stability.”

    sounds good on its own, but not in the context of: “the consequences of the central bank’s actions are seen almost exclusively through the lens of the IS curve – that is, through quantities such as consumption and investment. The wider consequences of monetary policy for the financial system as a whole receive less weight” which to me sounds frighteningly creditist and Bernankean. He talks about the bank-lending and bank-capital channel. He then essentially argues against those who suggest that all that is needed is to find the correct quantity of money regardless of transmission by saying,

    The amplified response to the easing of monetary policy, by itself, need not be a problem for policy-makers if they can fine-tune their monetary policy levers to take
    account of the amplification. Rather, the problem is the highly asymmetric nature of the mechanisms at play ‘on the way up’ versus the mechanisms ‘on the way down’.
    If the bursting of a property bubble impairs the solvency of the financial sector, then the dynamics ‘on the way down’ can turn into an extremely messy affair, involving
    a whole new set of mechanisms that did not figure in the initial inflating of the bubble. Default, financial distress, and inefficient liquidations will all conspire to
    exact very large economic costs.

    The bit that you quote is good. But you’ve been sneaky, you took it right out of context! He goes on to say:

    More systematic empirical evidence is not so encouraging for a country that undergoes a property-price boom financed by large increases in private credit.
    Borio and Lowe (2002a, 2002b, 2004) exhibit evidence that the joint occurrence of property booms and ‘excessive’ private-sector credit growth help predict banking
    distress, economic weakness and disinflation over a three- to five-year horizon.

    Combined with the last two sentences in the quote you picked, it’s unclear why you think the paper shows that Australia is an “island of sanity”. He’s clearly suggesting that things may not turn out so well for Australia – he thinks that we are building up “financial imbalances” which will put us into a downturn. He is subscribing to “what goes up must come down” thinking.

    It is one of the tenets of good banking practice that the
    banker should look at the borrower’s future cash flows, rather than be fixated by
    the value of the borrower’s collateral assets.

    He may not realize it, but that is the answer to his worries. When he talks about policy inflating bubbles, he is of course contradicting the “Tinbergen-style” recommendation. If he followed it, allowing monetary policy proper to focus only on flows of actual spending (NGDP), then he wouldn’t have to worry about asymmetries between making policy more expansionary or more contractionary, provided he was level-targeting the forecast. Expected NGDP can always be gotten to where you need it to be, and then the state of the financial sector is no obstacle to policy meeting its macro-stability objectives.

    Basically I think you’ve spoken prematurely in addressing the RBA as an ally. Consider the final three paragraphs:

    Taken together, the increased reliance on short-term incentives and the greater immediacy given by marking to market hold huge significance for the conduct
    of monetary policy. I opened this paper by noting that monetary policy works by manipulating asset prices, especially long-term interest rates. The orthodox view of
    monetary policy is that, although the central bank generally directly controls only the overnight interest rate, it can nevertheless manipulate long-term interest rates
    since long-term rates are determined by expectations of the future course of short-term rates (modified by the appropriate risk premium). By charting a path for future
    short rates, and communicating this path clearly to the market, the central bank can control long-term rates. Having thus gained control of long-term rates, monetary
    policy works through the IS curve – through quantities such as consumption and investment.

    This view of monetary policy reflects the origins of today’s macroeconomics in the IS-LM view of the world, except for the fact that the ‘LM’ part has now been
    discarded. We have ended up with an exclusively ‘IS’ view of the world. In this world, financial markets play only a passive role, populated with far-sighted but
    essentially passive agents. It is a moot point whether such a view of financial markets was ever valid, but it is becoming evident that it is less of a good approximation
    today. Fed Chairman Alan Greenspan’s ‘conundrum’ as to why long rates are so low today is a symptom of the breakdown of this view of markets.

    When fixed-income traders and hedge funds trade 10-year swaps, are they influenced primarily by their forecasts of the future path of the fed funds rate over the next 10 years? Perhaps. What is clear is that there will be other shorter-term considerations that enter into their calculations. Understanding these considerations
    and heading them off will become an increasingly important part of monetary policy. The distinction between monetary policy and policies towards financial stability
    are perhaps less clear-cut than is supposed.

    If I understand you correctly, Scott, you should fundamentally disagree with this view. (Enough to do a post?)

  6. Gravatar of Greg Ransom Greg Ransom
    8. August 2012 at 23:44

    The ‘Austrian’ label is dominated by a party line which is fundamentally anti-Hayekian as far as the picture of how to do economic science goes, ie as far as the empirical problem & contingent causal explanatory mechanism of economic goes. The ‘Austrian’ label is also tainted by a predominant party line on macroeconomic explanation which differs in substantive ways from core elements of Hayekian macroeconomics, eg on the endogenous nature of monetary disequilibrium in a money economy without central banking, and on the role of shadow money booms and crashes in the boom & bust & secondary deflation/depression cycles of the economy, and on the nature and definition of capital goods, etc.

    So, like George Selgin, I eschew the ‘Austrian’ label — you are welcome to it Scott.

    I prefer the ‘Hayekian’ label for the scientific research program advanced by Friedrich Hayek, both as a means of product differentiation and as a necessity in order to sidestep inevitable confusion and misunderstanding.

    But this listing of top ‘Austrian’ sites did give me an out-loud laugh. 😉

  7. Gravatar of Jim Glass Jim Glass
    8. August 2012 at 23:59

    Most economic historians use the WPI, which rose by 22% in 12 months

    After falling 10% the prior 12 months — a sudden increase in the WPI of 32 percentage points!

    Some pointed to the CPI, which only increased by a bit over 5%

    That’s 5.6% to be exact. After falling 10% the prior 12 months — a sudden increase in the inflation rate of 15.6%!

    If the CPI increased from the current level to 5.6% next year, would people be saying “only” 5.6%?

    If the CPI next year is 15.6% higher than this year, will people be saying it increased by “only 15.6%”?

  8. Gravatar of Wadolowski Wadolowski
    9. August 2012 at 00:35

    Prof. you’ve written:
    “Australia; an island of sanity in a world gone mad.”

    What if prof. Keen’s analysis is correct, and you’re making mistake by totally ignoring the level of private debt and there will be bubble burst in Australia:

    Would you change your mind, if the facts change?

  9. Gravatar of RebelEconomist RebelEconomist
    9. August 2012 at 01:24

    Yes, it is not inevitable that a banking crisis follows the bursting of an asset price bubble, if the banks’ domestic lending is a small part of their total business – the banknote issuing banks in Hong Kong are HSBC, Standard Chartered and Bank of China, for example. And it helps if the country concerned has net foreign exchange reserves of about 40% of GDP that it can use to buy 7% of its domestic stock market in a few days to stem a market crash, and it owns practically all of the land in the country so that it can underpin the property market by cutting off land supply.

    The example of Hong Kong in the Asia crisis is hardly relevant to the effect of the present financial crisis on the major global economies.

  10. Gravatar of Il Gattopardo Il Gattopardo
    9. August 2012 at 05:02


    You are right. Actually, HK experience is totally irrelevant to whatever Shin and Sumner have to say about monetary policy anywhere else. Don’t be surprised, however. We have seen too much BS about monetary theory and policy in the past four years because many economists have been trying to re-introduce money and finance into macroeconomics and at the same time to be seen as policy experts to help politicians to deal with the crisis. You can see how grotesque the situation is because they have to rely heavily on the authority of dead economists to make their points –points that were of little value when these economists were alive and are totally irrelevant today because of the many changes in how advanced economies work. They spend too much time searching for arguments in old books and papers when they should be trying to understand how these economies work.

  11. Gravatar of Sean Brown Sean Brown
    9. August 2012 at 05:42

    1. Bankruptcy laws in Spain – like most other countries, triggered upon mortgage default unlike some U.S. states – are very rigorous. Wage garnishment is a high % of income and ends only when you’ve paid off the principle. Despite this, I have heard extremely well-qualified people say the real rate of resi mortgage default there is 20%+. (If anyone wants, we can argue about why the reported 3% is wrong.) Part of this certainly has to do with higher LTVs – anywhere from 70% to 90%+, depending on who you believe – and the current 25% unemployment rate.

    2. Australia has a somewhat less punitive bankruptcy regime than Hong Kong, as well as significantly higher LTVs. (However, it is a more rigorous regime than the U.S. or Canada.) There is wage garnishing for 3 years, vs. 4 in HK, but no wages are garnished below $62k/year for a head of household and you keep your retirement-account assets. In HK, all assets are disgorged and for 4 years you must “make contribution towards your estate in bankruptcy out of your personal income as assessed by the Provisional Trustee /Trustee;” I am not sure what standard this equates to in real life.

  12. Gravatar of TheMoneyIllusion » What goes up must come down, but it need not come “back down” TheMoneyIllusion » What goes up must come down, but it need not come “back down”
    9. August 2012 at 15:01

    […] commenter named Wadolowski recently asked: What if prof. Keen’s analysis is correct, and you’re making mistake by totally […]

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