Friday, November 29, 2013

How A Central Bank Can Deflate A Housing Bubble Without Raising Interest Rates

Gavin Davies, writing in the Financial Times, explains how macro prudential regulation can enable the UK central bank to limit the rise in real estate prices and household debt in the UK.  Ordinarily, a central bank could raise interest rates to achieve that result;  however, that would also cause other asset prices to fall, since the present value of assets is a function of the discount rate.  The central bank does not want that to happen, and it also wants to encourage corporate investment and lending to small to medium enterprises, which has been the weak spot in the economy.  Therefore, it wants to maintain low short term interest rates.  The solution to this problem is to increase the underwriting standards on the issuance of mortgages.  That should discourage households and banks from inflating the real estate market, while maintaining the low interest rates that support asset prices and encourage corporate investment.

It is interesting to note that the Fed, under Alan Greenspan, chose not to use its authority to regulate mortgage underwriting standards in the US.  The decline in underwriting standards led to the issuance of mortgages that were likely to default.  Those mortgages were sold to investment banks which packaged them into securities that were sold to investors across the globe.  The global financial crisis may have been avoided if the Fed had used its authority to regulate mortgage origination practices in the US.

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