Turbulence in Asset Markets: the Role of Micro Policies

January 2003

Report of the Contact Group on Asset Prices

Executive summary

1. Introduction

Several factors suggest that asset markets affect economies more today than they did two decades ago. Financial liberalisation has led to a steady increase in the stock of financial assets, and the ownership of financial instruments has widened immensely. Continued economic integration has increased the correlation between asset markets and has reduced individual countries' scope to avoid market shocks. Financial liberalisation also appears to have led to larger credit cycles and to credit growth becoming more procyclical. Somewhat paradoxically, this development has taken place alongside the achievement of macroeconomic stability in many western countries. Hence, price stability has not automatically brought about financial stability. This insight, plus the fact that there already exists a vast body of literature on the linkages between asset prices and monetary policy, has spurred the current study to focus on the role of micro policies. The report wants to draw policymakers' attention to the fact that changes in taxes, regulations and disclosure policies can contribute to asset price fluctuations, and stimulate further work and discussion on these topics.

2. Micro policies and turbulence in asset markets: empirical evidence

Although asset price fluctuations are an inherent part of the present world economy, the empirical evidence presented in the study shows that they are also sometimes caused by policy failures or are unintended side effects, not least in the microeconomic sphere. Crashes in property markets have had more severe consequences than those in equity markets, which affects both financial and real stability. The reason is the important role real estate has as collateral in many economies. It is thus important for policymakers to pay particular attention to significant price swings in markets where assets are highly leveraged.

Prominent examples of poorly timed policies can be found in the wake of financial market deregulation among developed countries in the 1980s. Although deregulation itself was important, in conjunction with high inflation and strong fiscal incentives for asset purchasing it led to the build-up of price bubbles. In many cases, measures to cap the inflating bubble came too late, were too abrupt, and were implemented at a time when economic conditions were deteriorating anyway. The asset price drops were often followed by a wave of defaults and bankruptcies, and, in some cases, a major financial crisis. These lessons may be important as isdress rehearsalsls for policymakers in countries that have yet to complete their deregulation.

Evidence suggests that unsound incentive structures within the financial sector have contributed to excessive risk-taking, both by individual loan managers and by entire financial institutions. In addition, the current Capital Accord has been mentioned as a source of procyclicality and financial vulnerability. The report briefly reviews three measures to counter these effects: dynamic provisioning, fair value accounting and loan-to-value ratios. Another distortion, brought about by taxation systems, is the tax deductibility of debt financing. The income effects can be dramatic as countries go from a high-inflation to a low-inflation environment, and may exacerbate the initial asset price drop generated by the rise in real interest rates.

3. Policy discussion

The main conclusion of the report is that the use of discretionary polices to directly influence a particular asset price development is fraught with difficulties. Though necessary in some cases, such measures are hard to fine-tune and also create moral hazard problems. Rather, countries should commit to building a robust financial and regulatory system, where on the one hand incentives to participate in the build-up of price bubbles are small, and on the other booms and busts in asset markets have limited consequences for the financial system. When it comes to taxes, it is important that present structures do not unintentionally amplify asset price fluctuations. In this respect, the removal of tax incentives such as deductions for loans on housing can be effective. In addition, for asset classes that are highly integrated internationally, such as equity, there is very little room for policy initiatives on the national level. Transaction taxes are not likely to be a preferred policy tool under any circumstances, particularly at the national level.

The growth and internationalisation of asset markets have increased the need for transparency and information disclosure, both from individual firms and from public authorities. In principle, greater transparency should lead market participants to make more informed assessments and reduce the incidence of phenomena like disaster myopia and herd behaviour. Authorities should work to increase risk awareness and reduce moral hazard problems within the financial sector.

The report concludes by pointing out the risk of these issues not being given sufficient priority on the policy agenda. One reason for this is that financial crises are low-frequency events, another that the responsibility is shared between different institutions. Moreover, continued economic integration makes national policy intervention difficult and increases the need for international coordination of financial regulation and supervision.

Report Turbulence in Asset Markets: the Role of Micro Policies: