RDP 2010-06: Asset Prices, Credit Growth, Monetary and Other Policies: An Australian Case Study 1. Introduction

The global financial crisis provided a stark reminder that large falls in asset prices combined with high leverage can severely damage economies. In the United States, which has been at the core of the financial crisis, house prices declined by 25–30 per cent between 2007 and 2009, ultimately contributing to the largest decline in economic activity in over 60 years. Global exposure to the US economy and a sharp decline in confidence was the catalyst for the first decline in global GDP in the post-War period. In addition, house price declines in Ireland, Spain and the United Kingdom contributed to a significant weakening of these economies. Given the scale of the damage, it is not surprising that these events have reinvigorated the long running debate about the role for policy in maintaining financial stability, including whether or how monetary policy should respond to changes in asset prices.^[1]

While much of the earlier debate focused on identification of asset-price bubbles and whether monetary policy should respond to them, the debate appears to be shifting towards how policy should respond to financial imbalances more broadly. This reflects a growing recognition that asset price increases that are backed by a substantial rise in leverage and a less prudent approach to risk management by financial institutions can be dangerous. The global financial crisis has clearly demonstrated that a policy of ‘cleaning up the mess’ after a collapse in asset prices is problematic, especially if the collapse is associated with significant damage to financial institutions. This strengthens the case for taking earlier action in order to avoid a damaging correction later on.

Nonetheless, there is much debate about the appropriate nature of the policy response along two broad strands. The first regards how much, if at all, monetary policy should act to stem financial cycle upswings. The second, and closely related strand regards the scope for other policy instruments, such as so-called macroprudential tools. This paper suggests that there is a need to shift debate away from the extremes towards the question of the degree of policy intervention (or ‘leaning’) that is appropriate and the mix of policies that is likely to be effective in maintaining stability of the macroeconomy.

Understanding the effectiveness of the various approaches is, however, hindered by the limited experience of monetary or other policies being used explicitly to respond to financial imbalances.^[2] The few examples commonly cited include: Hong Kong in the early 1990s, with controls on loan-to-valuation ratios (LVRs); Spain's adoption of dynamic provisioning from 2000; the response in Australia to rapid growth of house prices and credit between 2002 and 2004, with a combination of ‘open mouth operations’, a modest increase in policy rates and some regulatory actions; and the Swedish experience using a similar approach in response to rapid growth in house prices and credit between 2005 and 2007.

This paper provides a detailed case study of the Australian experience in the early 2000s.^[3] Between 1997 and late 2003, housing prices in Australia more than doubled, increasing by around 40 per cent over 2002 and 2003 alone. There was also a rapid increase in housing credit (of 20 per cent per annum in 2002 and 2003), particularly for the purchase of residential investment properties. The boom ended in late 2003, with national housing prices broadly flat over the subsequent 18 months (and falling in the two largest capital cities) and investor demand for residential property easing significantly. This turnaround is an example where a range of policies seemingly came together (albeit in a not explicitly coordinated fashion) to ‘lean against’ emerging imbalances at a time when the growth in residential property prices seemed inexorable.

In the five years following the 2003 turnaround, dwelling prices grew at around the same pace as household disposable income and GDP growth averaged 3 per cent per annum. Indeed, the early shake-out of the housing market may be one reason why the Australian housing market and financial system were relatively well placed to weather the global financial crisis. Of course, the generally benign outcome is also likely to have reflected a number of other factors. Among them, Australia benefited from a large rise in the terms of trade starting around the time that dwelling prices peaked. More generally, growth in the global economy was very strong over the period from 2003 to 2007.

One important part of the policy response was a ‘public awareness campaign’ by the Reserve Bank, highlighting the risks to households and the economy if the existing trends in housing prices and borrowing continued (Macfarlane 2006). As part of this campaign, from mid 2002 there were an increasing number of ‘open mouth operations’ conducted by senior officials from the Reserve Bank. These public statements were widely reported in the media, and intensified during the period of most rapid growth in house prices. In addition, monetary policy was tightened over this period; in mid 2002 there were two 25 basis point increases, and then another two increases of the same amount in late 2003. While the increases reflected broader macroeconomic developments, they were accompanied by statements that expressed significant concern about the pace of credit growth and housing price inflation, which could fuel imbalances if sustained.

During this episode, the Australian Prudential Regulation Authority (APRA) publicly raised its concerns with banking institutions regarding housing lending standards and undertook a detailed stress test of their housing loan portfolios. The Australian Taxation Office (ATO) also took a stricter approach to enforcement of housing-related tax laws. In addition, authorities took action against what appeared to be fraudulent activity in the rapidly expanding property investment industry, exposing and prosecuting agents of a prominent ‘get-rich-quick’ scheme.

The remainder of the paper is structured as follows. Section 2 reviews the postfinancial crisis debate on asset prices and monetary policy, and the literature on the policy responses to asset price upswings. Section 3 provides a brief history of Australia's experience with cycles in credit and asset prices and discusses events in the Australian housing market in the early 2000s. Section 4 describes the range of policy measures put in place in Australia between 2002 and 2004 in response to rapid house price and credit growth, and examines the media response to the Reserve Bank's public awareness campaign. Section 5 concludes.

Footnotes

Issing (2009), Trichet (2009), Bernanke (2010), Blanchard, Dell'Ariccia and Mauro (2010) and Goodhart (2010). [1]

Indeed, Greenspan (2010) claims that: ‘There are no examples, to my knowledge, of a successful incremental defusing of a bubble that left prosperity in tact [sic]’ (p 45). [2]

This episode is covered briefly by Cecchetti (2006), Fatás et al (2009) and Posen (2009). [3]