Stephen King: MPC should put some madness in its method

Bank has to persuade people there will be no housing bailout
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The Independent Online

Ronald Reagan's departure from this world got me thinking about madness. Not so much general insanity but the more specific peculiarities of the nuclear stand-off that Reagan inherited on coming into office. Mutually Assured Destruction (MAD) had become a central feature of the Cold War in the 1960s and 1970s. And mad it was. For it to work, you had to believe that your leaders were nuts.

Ronald Reagan's departure from this world got me thinking about madness. Not so much general insanity but the more specific peculiarities of the nuclear stand-off that Reagan inherited on coming into office. Mutually Assured Destruction (MAD) had become a central feature of the Cold War in the 1960s and 1970s. And mad it was. For it to work, you had to believe that your leaders were nuts.

Contemplate these three choices. No one dies. Half the world's population dies. All the world's population dies. Putting on my utilitarian hat, I can easily rank these options in order of preference. First choice? No one dies. Second choice? Hmm, no really palatable options here... but... well... OK, if push comes to shove, half the world's population dies. Third choice? The end of the human race.

To get to the first option, we all had to believe that our leaders preferred the third option to the second option. If either superpower launched a pre-emptive nuclear strike - mad enough in itself - we had to believe that the leaders of the other side would hit back. Our leaders, therefore, had to give the impression - even better, really had to believe - that the end of the human race was a better outcome that having only half the world's population wiped out. And as none of us would reach this conclusion rationally, it followed that MAD really was mad.

The moral of this Cold War story is that policymakers sometimes have to behave in ways that no-one, rationally or morally, would ever consider to be sensible. All of which is an ethical and game-theoretic preamble into the problems facing the Bank of England. No fingers on the nuclear trigger, perhaps, but plenty of nervous digits hovering over the interest rate trigger. The Bank has now raised interest rates in two consecutive months. What does this mean? What is the Bank trying to tell us?

Obviously, the Bank isn't directly concerned with the demise of the human race. It is, though, concerned about other things. In a broad sense, it's worried about inflation. More narrowly, it frets about the housing market. And it's here that the Bank's version of MAD comes into play.

Put yourself into the position of a potential house purchaser. You're wondering about whether to dip your toes into the housing market. Should you buy now? Or should you wait? Prices are, to say the least, a bit on the high side. Then again, you think about the pundits' warnings of an imminent house price crash and realise that, so far, they have been proved persistently wrong - and the longer you've held off, the more expensive housing has become. So, taking a deep breath, you plunge in. After all, if you don't buy today, you'll have to pay even more tomorrow.

But you also know something else. Should house prices start to decline, the Bank of England will be forced to cut interest rates. So, even though the capital value of your property may fall, at least you have the comfort of knowing that your debt-service costs will come down, thereby alleviating your financial distress.

With these beliefs, house prices will only carry on rising. So long as people believe that house prices are more likely to rise than fall and that the Bank can offer a bailout should things go wrong, they will feel confident in continuing to buy houses and house prices will continue to rise beyond the bounds of common speculative decency. And this is where madness comes in. Somehow the Bank has to persuade people either that there will be no bailout or, alternatively, that any bailout will be ineffectual.

I'm describing a classic moral hazard problem. Despite the increases in interest rates seen so far, the housing market continues to look, smell, and feel like a bubble, one that is being inflated partly because people think that the Bank surely wouldn't want house prices to come crashing down. The left-hand chart shows house price inflation, as measured by the Halifax house price index, going back to the mid-1980s. The late-1980s bubble may have been on a slightly bigger scale than today's, but the longevity of this latest surge in prices is truly impressive, an observation only emphasised by the latest - unexpected - rebound.

So, what to do? There are two possible approaches. First, the Bank - perversely - has to hope that inflation surprises on the upside. If this happens, the Bank can push interest rates up to higher levels and keep them there. If inflation is too high, rates can't really come down even if the housing market starts to weaken. And if we all know that, perhaps we'll put our speculative pounds back in our pockets and become a little more cautious about investing in bricks and mortar.

Second, the Bank can still allow people to believe that there will be a bailout but that the bailout will only start when interest rates have reached painfully high levels. One way to get across that belief is to abolish the policy of interest rate gradualism that dominated thinking earlier this year. Instead, the Bank could move to a more hawkish policy that makes clear its determination to do something about the house price gains, notwithstanding the current relatively low rate of inflation.

Arguably, both options are becoming more relevant. Although the impact of higher oil prices on inflation is ambiguous - inflation will only rise on a sustained basis if companies are able to pass on their higher raw material costs through higher prices - the threat to inflation could be construed large enough to allow the Bank to adopt a more hawkish tone for a given rate of house price inflation.

Meanwhile, as the language of gradualism has slipped and the frequency of rate increases has lifted, financial markets are pricing in more aggressive increases in interest rates. The right-hand chart, for example, shows interest rate expectations for the next two years as they were at the beginning of 2004 and as they are now: they've gone up a long way, even though inflation itself remains well-behaved.

The Bank could now drum this message home more aggressively by making its worries about the housing market a lot more explicit. There's a good reason for doing so. The more that house prices rise today, the more debt consumers will take on board. The more they are indebted, the more they are exposed to any subsequent house price decline. And the more that house prices weaken - a function in part of how far they were allowed to rise in the first place - the less likely it is that any bailout will work, thus reducing the Bank's ability to hit its inflation target over the medium term.

Central bankers have, of course, tried to sell this kind of message before. Alan Greenspan famously referred to "irrational exuberance" back in 1996 to little avail. We knew then, and we know now, that, when things go wrong, central banks cut interest rates. And that, ultimately, is the problem that policymakers have with financial and real estate bubbles. They need to persuade people that the bailout either won't happen or won't work. Doing that is no easy task. It's the economic form of MAD: to persuade people to have a sensible approach to real estate, central bankers may have to adopt an overly threatening approach to monetary expectations. Mutually Assured Destruction worked only because the best outcome was achieved through the threat of the worst outcome. Similarly, the Bank of England's best outcome is a soft landing for the housing market and the economy: but, to achieve this, it may have to hint at its willingness to deliver the worst outcome. Fortunately, though, by doing so, it may never have to go there.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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