Housing bubbles in Sweden and Germany and the over-reliance on monetary policy

Today’s commentary

Summary: The central banks in Sweden and Germany are concerned about overheating economies as the European sovereign debt crisis has led to a net inflow of investment into their housing sectors. If one looks at European economic policy, these bubbles are the natural outgrowth of a continued over-reliance on monetary policy in economic orthodoxy. More bubbles will follow.

Here’s what is happening on the ground. In Germany, the Deutsche Bundesbank has issued a formal warning on overheated residential property markets in seven German cities: Berlin, Cologne, Düsseldorf, Frankfurt, Hamburg, Munich and Stuttgart. The Bundesbank’s report says that the housing market is as much as 20% above trend in these markets, with German property experts openly talking about “local bubbles” the way US experts did a decade ago. This situation has been building for at least three years now.

In Sweden, Dagens Nyheter recently highlighted the Swedish property market as overheating (link in Swedish). And here yet again, as in Germany, it is the housing markets in the big cities like Stockholm and Gothenburg where we see the overheating. The Swedish paper writes that one reason for the overheating is the high level of demand for residential property (due low interest rates), which has caused selling prices to far outstrip asking prices in the last three quarters, according to the SBAB Broker Barometer. As in Germany, this situation has been building for years in Sweden, creating a concomitant household debt problem.

Though I did not mention it in the summary above, the UK residential property market also deserves attention here because it has exhibited similar symptoms. On the back of the UK government’s Help-to-Buy scheme, demand for housing is vaulting upwards in Britain. In the last month alone, for example, average London house prices jumped 50,000 pounds. House prices throughout Britain are at an 11-year high. The widely followed UK property website Rightmove is openly warning about a bubble.

So what’s going on here? In a phrase, monetary policy. Let me explain.

During the Great Depression, there was a sea change in thinking about the economy and government’s role. Laissez-faire went away and regulatory controls and government intervention increased. In the United States, the Great Depression was won over by most accounts only after the large increase in government spending associated with World War 2 that left behind accumulated government debt above 100% of US GDP. In the UK, government debt approached 250% of British GDP.

After the war, Keynesian policies reigned supreme and this meant government policy was activist, particularly in fiscal matters. During the 1950s and 1960s, economic growth was high everywhere in the developed world, coupled with low inflation and low unemployment. However, in the 1970s, after the US severed the gold link and because of two major oil shocks, the economic situation changed drastically. We saw considerable levels of volatility in currencies, high inflation, great economic volatility, and market turmoil. This led to the rise of the monetarists and to a decline in the legitimacy of fiscal activism and government itself. The economics profession turned away from fiscal policy altogether and monetary policy reigned supreme. And despite the financial crisis, economic orthodoxy has not changed considerably at all. Monetary policy still reigns supreme.

This is why we are seeing bubbles everywhere.

This period of monetary policy dominance is what I call the asset-based economic model. It is based on two fundamental asymmetries in macroeconomic policy. First,  the inflationary period in the 1970s led to a decline in fiscal policy activism but it did not lead to a decline in government intervention because the lesson from the Great Depression that economists learned was that doing nothing in crisis is the worst policy. After World War 2, economic orthodoxy was controlled by two competing but related schools of thought. The Keynesians believed in government activism. The monetarists believed in limited government but still adhered to the view that doing nothing was the worst policy response. And so monetarism puts monetary policy at the core of economic policy making, with the central bank considered independent of partisan political influence and with money and credit as the core issue in terms of inflation and crisis.

We can see the overtones of this thinking in the financial crisis response.

In Europe, the European Central Bank has lowered interest rates and flooded the system with liquidity by loaning money out to euro zone banks on favourable terms. Meanwhile, the use of fiscal policy was limited to the acute crisis period. Now that the acute phase of crisis is over, policy makers demand fiscal restraint, with countries experiencing the greatest fiscal deficits forced into austerity, a kind of fiscal activism in reverse gear. Clearly, the goal is looser monetary policy and tighter fiscal policy, making monetary policy the predominant policy tool.

In the United States, the policy response has been more expansionary but similar in thrust, with monetary policy ascendant. The Federal Reserve also lowered rates, in the U.S. to the zero lower bound. But the Fed, like the Bank of England, went one step further by engaging in quantitative easing which added a tremendous amount of excess reserves to the banking system. The hope in both cases was that the excess reserves would create a situation in which credit growth expanded. Meanwhile, the Federal deficit is back to where it was before the crisis after an unprecedented period of deficit reduction. The conservative publication Investor’s Business Daily calls it the deficit reduction “far above any other fiscal tightening since World War II.” With a government shutdown and sequester used as tools to reduce government spending further still, it is clear that the goal is for monetary policy to do the heavy lifting if any economic support is needed.

The problem with monetarism and the over-reliance on monetary policy is that it creates bubbles.

First, the quantitative easing policy of the central banks in the UK, the US and Japan does not work as advertised because there is a faulty thinking about the transmission mechanism. Just today, I read an article in the UK press about the genesis of quantitative easing as a policy tool and the economics is all wrong. The progenitor of QE, a German Professor named Richard Werner was complaining that the QE he envisaged of central banks borrowing from commercial banks has never come to pass. Werner says the policy was about credit creation and his QE policy would work while the present one doesn’t. That’s totally wrong and based on the false money multiplier way of thinking. Banks are never reserve constrained. The credit comes first and reserves are created so the central bank can maintain an interest rate target. Adding reserves DOES NOT create credit. The only transmission mechanisms in quantitative easing are the interest rate expectations and portfolio preference channels. This means QE is about lowering discount rates and increasing risk appetite. That’s it. There is no direct path from QE to credit creation. QE, therefore, necessarily depends on increasing asset prices, which is why the potential to create bubbles is a problem.

Second, interest rate policy as practiced is asymmetric: cutting aggressively during an economic trough and raising slowly during the expansion. Unconventional tools like QE are only used now because interest rate policy is less effective when rates are this low. Interest rate policy is the primary tool of central banks. And because policy makers expect it to be the dominant macroeconomic policy tool, policy is inherently asymmetric in nature in order to help the economy recover from economic troughs without the need for fiscal activism. We saw this during the irrational exuberance episode in the late 1990s and again last decade when Alan Greenspan’s Fed raised rates in slow telegraphed 25 basis point increments during the housing bubble for fear of killing off the recovery from the last bubble too early. This policy asymmetry necessarily increases asset prices in a way that creates the potential for asset bubbles.

That’s what is happening in Germany, Sweden and the UK. It is also something to watch in the US housing market as well as in high yield.

What I think this means for traders and investors is that they need to watch out for huge asset price crashes in cyclical downturns. I believe we are still in a secular bear market, the hallmark of the period being multiple compression in equity markets and large market declines at economic troughs.  Asset prices are kept artificially high during an economic upswing due to reflationary monetary policy. Economic growth is deceivingly robust where the asset prices are increasing the most. The higher asset prices eventually become bubbles in some areas, creating a concomitant resource misallocation into those asset class(es). When the business cycle turns down, the downturn is negatively impacted by the discovery of monetary policy induced resource misallocation and the phantom growth associated with it. The discovery of this phantom growth is what leads to the violent nature of the pull back in asset prices and the contraction of equity multiples as risk on turns to risk off.

We are still in an upswing right now. And there is no indication that this upswing is going to end in the near future. When it does end, investors will need to be thinking of ways to minimize risk and protect wealth. We are not there yet.