Question

What will happen to the money multiplier and monetary base during a rampant asset inflation period and then during the financial crisis triggered by the eventual bursting of the asset bubble? What will be the effect of the changes on the asset inflation in the first sub-period and on the post-crisis recession in the second subperiod?

Answer 1

The three stages of an asset bubble

asset bubble period into the following three stages: the seeding stage, the development stage and the final stage

The seeding stage

seeding stage usually occurs when the asset price has a chance to exhibit a sustained rebound (or rise) from a trough for a few months or quarters. The sustained rise in the asset price in the first few months or quarters would then create an expectation of further rise in the asset price (i.e., expectation of asset inflation). This change in expectation will in turn trigger some major changes in economic behaviors which would then fuel further rises in the asset price

A. Direct increase in asset demand

For example, the expectation of further rise in the asset price could substantially augment individuals’ and firms’ demand for the asset. Throughout the seeding stage, the development stage and the final stage, individuals and firms will invest more and more funds into that asset. Some will even increase their investment in that asset with funds originally meant for other purposes (e.g., retirement money or life-time savings for individuals; and working capital, investment funds or other company money for firms). Many of the market participants will also increase their investment in the asset through higher leverage and borrowing.

B. Monetary support for the increase in asset demand

In addition to the above direct increase in the demand for the asset, there will also be behavioral changes on the monetary side that will provide the necessary fuel for further rises in the asset price. To understand this, first consider the following simple model:

M = C + D

MB = C + RR + ER

and M=m*MB

where the money supply (M) is the sum of cash (C) and bank deposit (D) held by the general public; the monetary base (MB) is the sum of cash held by the general public and the required reserve (RR) plus the excess reserve (ER) held by the banks; and the money multiplier (m) is defined as the amount of money supply (M) created by the monetary base or high power money (MB).

C.Past example of a substantial increase in money supply during an asset bubble

In fact, as documented in the literature on the 1997 Asian financial crisis, banks in Thailand and many ASEAN economies had borrowed substantial short-term US dollar loans (i.e., less than 1 year) to finance the increase in domestic loans during the asset bubble in 1990-97. On top of that, the rampant rises in domestic shares prices and property prices at that time had induced enormous short-term capital inflows or hot money into these economies. Because of the rise in the money multiplier and the monetary base, the loan growth in these economies were well above the real GDP growth during the bubble period.

The development stage

Once the expectation of further rise in asset price causes the above changes in economic behaviors, the asset market has entered the development stage. It should be highlighted that the upward force due to these changes in economic behaviors would be enormous.

A.Large number of vicious cycles

vicious cycle between the rise of property prices and the rise of shares prices. That is, a rise in property prices will raise the profits and hence the prices of property shares, which will in turn raise the shares prices of other sectors through an indicator effect, a portfolio adjustment effect and other spillover effects. The rise in share prices will in turn induce some share investors to invest in more properties and hence support further rise in property prices. Furthermore, there will be a series of vicious cycles among the rises of asset prices, consumption, investment and output. That is, a rise in property prices and share prices will increase consumption through the wealth effect, while a rise in property prices will increases the developers’ investment in real estate development and a rise in shares prices will increase firms’ investment through the Tobin’s q effect , These rises in consumption and investment will increase output through the standard multiplier effect.

B. Upward spiral

Meanwhile, there will be upward spirals among property prices, rentals, general prices and wages, which would again fuel or support the rise in property prices.

c. Built-in leverages

On top of the above vicious cycles and upward spirals, the increased usage of the built-in leverages in the financial system would also fuel the rise in the asset price.

D. Risk from unchecked financial innovations

On top of the built-in leverages, there could also be financial innovations that would fuel the asset bubbles. For example, during the asset bubble period before the 2008-09 financial tsunami in the US, there were emergence and then substantial increase of new financial products such as the mortgage backed securities (MBS), the collateralized debt obligations (CDOs) and even the CDOs.

The final stage

In the final stage, the sustained and powerful rise in asset price in the previous stage will cause herding behavior. . the herding behavior will attract or force more participants to join the herd even if some of them beleive that the asset price is highly overvalued.

Two types of bursting

once the bubble reaches the final stage, a bursting of bubble will be just a matter of time instead of whether-or-not. Here, there could be two types of bursting, and the eventual outcome will depend on whether there is a large enough negative shock to trigger a bursting of the bubble at the early part of the final stage. In the lucky case that there is a large enough negative shock at the early part of the final stage (i.e., before the bubble become too large), the bursting would only cause an economic crisis and severe recession, but not yet political and social instability

In the unlucky case that there is no large enough negative shock at the early part of the final stage, the bubble would have the chance to grow to an extremely big one. By then, even the government will be “kidnapped” by the gigantic bubble.

The early stage of a financial crisis

The first fall and then the beginning of a downward inertia

In the final stage of an asset bubble where close to 100% of the potential investors have already invested close to 100% of their available funds in the asset, the rise in the asset price has to slow down and then stop. Thus, once the asset bubble reached the final stage, there would be two possible cases.

The first case is where there is no large enough negative shock to trigger the bursting at the early part of the final stage. In such a case, the bubble would have the chance to grow to a gigantic one so that even a very mild negative shock is enough to trigger a bursting of the bubble.

The second case is where there is a large enough negative shock that trigger a bursting of bubble at the early part of the final stage. Whatever the case, once the bubble reaches the final stage, there will sooner or later be a fall in the asset price.

As the assert price is substantially overvalued at this stage, once there is a meaningful first fall, some asset holders will be induced to sell the asset before it is too late and many highly leveraged investors will be forced to sell the asset. This will cause further fall in the asset price which will in turn trigger more and more asset holders selling the asset, thus resulting in a downward inertia in the asset price.

the pattern of this process in the property market could be very different from that of other financial markets such as the stock market, the commodity market and the foreign exchange market. Thus, it is necessary to discuss the two cases separately.

A. The initial financial deleveraging and the beginning of a downward inertia in the financial asset market

inancial asset markets in which there is an organized exchange or over-the-counter trading platform so that the homogeneous assets could be traded in just a few seconds with very low transaction costs. Once there is the first fall, many of these asset holders will try to rush in front to each other to sell the asset, which will cause further fall in the asset price, and induce (or force) more asset holders to sell the asset. When more and more investors do so, the selling will cause a quick and sharp plunge in the financial asset price. Such a pattern is further aggravated by the investors’ knowledge or previous experiences that falls in financial asset prices from the overvalued levels are usually quick and sharp. That is, many experienced investors will try to sell a significant amount of the financial assets at the initial stage of the correction

B. The downward inertia in the property market

For the case of property market, the pattern of the fall might be different because of the higher transaction costs and longer time involved in doing the one-to-one bilateral trading of the heterogeneous asset (i.e., properties could be very different from each other in terms of location, quality, window view and direction, floor level and so on). In addition, unlike the financial assets, properties also plays the important role of meeting the housing needs of most property owners.

Expectation of further fall in asset price and changes in economic behaviors

In the case of an asset bubble, the initial fall will trigger a downward inertia and hence an expectation of further fall the in asset price. The latter will in turn cause a large number of negative changes in economic behaviors, which will fuel further plunges in the asset price.

In the case of an exchange rate crisis, the downward inertia of exchange rate and expectation of further fall in the exchange value of the currency will induce exporters and those domestic residents with foreign currency to delay or stop remitting the foreign currency back home. The downward inertia and expectation will also induce importers and other domestic residents to speed up outward remittance and start making capital flight out of the economy. In addition, more participants will hedge their exchange rate risk through substantial leveraged selling in the currency futures. Worse still, more and more domestic residents, hedge funds and international speculators will take huge leveraged short positions in the currency futures market. Through covered interest arbitrage, all these hedging and speculative activities will be transmitted into enormous selling pressure in the spot exchange rate market, and a liquidity crunch in the domestic money market.

In the property market, there will also be an increase in the supply of properties when more property owners are induced or forced to sell their properties. With the expectation of further fall in property prices, there will also be a substantial reduction or abrupt disappearance of speculative demand, investment demand and panic demand for properties. Thus, there will be a substantial increase in the supply of properties and an abrupt reduction in the demand for properties. These will cause a further fall in the prices of properties, other property-related assets and property derivatives, thus providing the necessary fuel to push the whole financial system towards a full-blown crisis

Changes in economic behaviors on the monetary side

Along with the above changes in economic behaviors in the direct demand for and the supply of the asset, there will also be changes in economic behaviors on the monetary side

From the early stage to a full-blown crisis: some disastrous vicious cycles

With the expectation of further fall in the asset price and the ongoing changes in economic behaviors outlined, there would be further fall in the asset price. This will in turn trigger a few disastrous vicious cycles, which could push the whole financial system into a full-blown crisis.

The post-crisis recession

When the economy and its financial system reach the above full-blown crisis stage, there will be emergence of more vicious cycles and downward spirals, which will push the economy into a prolonged post-crisis recession (i.e., many years of recession beyond the crisis period). For examples, in addition to the vicious cycle between further fall in property prices and further fall in financial asset prices, there will be a series of vicious cycles among further fall in asset prices, further fall in consumption, further fall in investment, and further fall in output. That is, further fall in asset prices will mean lower wealth for consumer and hence further fall in consumption through the wealth effect

The reduction in consumption will in turn trigger a multiple contraction of output through the standard multiplier effect. In addition, through the Tobin’s q effect, further fall in property prices will cause further reduction in developers’ investment in real estate development, and further fall in shares prices will cause further reduction in firms’ investment. The fall in investment will again cause a multiple reduction in output through the standard multiplier effect, while the fall in output will cause another round of reduction in investment through the accelerator effect. Furthermore, the fall in consumption, investment and output will cause lower demand for asset, and hence more rounds of fall in asset prices and fall in aggregate demand.

There will also be a downward spiral when lower output and higher unemployment cause a lower wage, rental and general price, which will in turn mean weaker support for property prices and shares prices. By then, the economy will be trapped by a prolonged post-crisis recession with negative output growth, high unemployment as well as slowly falling wages and prices.

Lessons from policy measures adopted against financial crises

Bursting of stock market bubble before the Great Depression in the 1930s, the Global Financial Tsunami in 2008-09 and the European Debt Crisis in 2010-12 were only followed by severe recessions instead of great depressions in the related countries. Thus, a careful review of the policy measures in these crises could provide us valuable insight on potential policy measures that could be used to mitigate the economic pains triggered by a financial crisis in the future.

Lessons from the European Debt Crisis

During the European Debt Crisis, political problems among the European Union (EU) members had however resulted in a delay in the use of the European version of Quantitative Easing (QE). As a result, the sovereign debt crisis had caused a rapid deterioration of the European economy. Fortunately, the European Central Bank (ECB) was eventually allowed to announce its own version of QE (i.e., the Long Term Refinancing Operations, LTROs and the Outright Monetary Transactions, OMTs), which had helped the stabilization and then the strong rebound of the sovereign debt markets of the crisis-hit economies. Meanwhile, the disappearance of the fear discount of a potential collapse of the whole European financial system had also triggered a strong rebound of the European and the global stock markets

EU had also implemented the stress tests on its financial institutions, it did not force the financial institutions to take the pain to raise capital by issuing new shares at the low “crisis prices”. As such, European banks and non-bank financial institutions were in far from healthy positions. Together with the damages due to the delay in the use of QE, this had contributed to a much weaker European economy during the post-crisis period when compared with that of the US. Thus, the above comparison between the EU and the US suggests that unnecessary delay in the use of QE would give the crisis more time to cause damages on the economy, which would in turn imply weaker recovery of the economy.

Lessons from China’s ultra fiscal expansion

Before the implementation of the QE, the US government had once attempted to use fiscal stimulation to offset the negative impact of the financial crisis. Nevertheless, as the deepening of the financial crisis at that time had already caused substantial deterioration of the economy, the fiscal stimulation was too late and too small to stop or slow down the deterioration.