Speaking to the Economic Club of New York about Britain’s economic recovery, Bank of England Governor Mark Carney drew inspiration from Charles Dickens’ nineteenth-century parable about miserliness contained in his celebrated novel “A Christmas Carol”.
Perhaps the governor should consult a much older work, Henry of Huntingdon’s twelfth-century “History of the English People”, which relates the story of King Canute unsuccessfully attempting to hold back the tide. Canute failed and thereby demonstrated to his flattering courtiers that not even the king could rule the waves.
Carney has embarked on a similarly doomed exercise, keeping interest rates at historically low levels while relying on qualitative and quantitative controls to prevent an unsustainable housing boom.
The Bank’s new-found enthusiasm for quantitative controls, renamed macro-prudential policies, reverses a 40-year trend that has seen central banks abandon direct regulation of the volume and type of loans in favour of a system of price-rationing through interest rates. It marks a return to the system which prevailed in the 1950s and 1960s before lending was deregulated. As the Bank explains on its website:
Prior to September 1971, the main policy objectives of the authorities had been control over the supply of credit available to the private sector and control over the level and structure of interest rates. The former objective was attained by the imposition of quantitative and qualitative restrictions on bank lending.
That sounds a lot like a description of the macro-prudential controls the Bank intends to employ in future to mitigate the risks of a housing bubble and an unsustainable build-up of household debt.
In the minutes of the last Financial Policy Committee meeting, held on November 20, the Bank outlined no fewer than ten measures it is already taking or could take in future to mitigate housing-related risks. These range from encouraging banks to build up capital, enhanced supervision, stress tests, and eliminating subsidies for residential property lending to tighter underwriting standards, applying stricter affordability tests, monitoring interest rates lenders are actually applying in the tests, and recommending changes to the government’s help to buy scheme which subsidises mortgages with high loan-to-value ratios.
Finally, there is a catch-all provision:
The Committee noted that it could, if necessary, take actions to enhance the resilience of lenders’ balance sheets by giving a recommendation or direction to increase capital requirements. Depending on the nature of the risks to resilience, the Committee could decide to apply the requirements to specific types of mortgage lending, just to new lending, or to the entire portfolio of loans.
The Committee could also take actions where it was concerned about the risks to financial stability stemming primarily from the indebtedness of households. For example, it could recommend that regulators curtail the extension of mortgages with certain characteristics through limits on the loan-to-value or loan-to-income ratios of mortgages.
In Table 5A of its November Financial Stability Report, the Committee sets out a long list of potential tools for controlling lending. It cites examples from Canada, Hong Kong, South Korea, Singapore and New Zealand where non-price controls have been used successfully to control housing finance.
The Bank acknowledges underwriting standards on mortgage lending and household finances have tended to deteriorate during previous cycles of house-price inflation. If interest rates remain low and encourage a continued strong rise in prices this time, there is a risk that mortgage standards will again deteriorate as potential borrowers stretch themselves and banks ease lending policies in order to help them.
Theory and evidence suggest that low long-term interest rates and strong cross-border capital flows to advanced economies can act as important determinants of property price dynamics.
Low interest rates can also make it attractive for households to take on more debt. Indeed, there is some evidence that this has already been happening in the current housing upturn with households using longer mortgage terms to enable them to afford larger loans.
Recently, more than half of first-time buyers have been taking out a mortgage with a term exceeding 25 years, the Bank cautions. Twenty-five years has historically been the typical term of a mortgage in the United Kingdom. Other risk indicators include more high loan-to-income lending and a growing number of lenders offering mortgages with loan to valuation ratios in excess of 95 percent.
Britain has been here before, deliberately fueling a housing boom to pull the rest of the economy out of a recession. The risks when the boom gets out of hand are well understood by policymakers. “Given its importance to balance sheets in the United Kingdom and many other economies, property has played a central role in many previous economic and financial crises,” the Bank admits.
But this time will be different, according to policymakers. The Bank hopes macro-prudential controls can break the link between house prices and imprudent lending, and maintain high underwriting standards even as the housing boom matures.
In his speech, Carney was explicit about the relationship between low interest rates and macro-prudential controls. “The synergies of combining monetary and macro-prudential authorities in one institution (the Bank) could be considerable,” he told his audience. “Going forward, financial reforms will help guard against excessive pro-cyclicalities that could emerge in a ‘low for long’ environment.”
In case anyone missed the point, he concluded the prospect of historically low interest rates continuing for some time “puts a premium on macro-prudential policies and financial reforms to manage the associated risks.”
At low interest rates, there is likely to be excess demand to borrow money to buy houses, much of it from borrowers of dubious credit quality using it to buy dangerously over-priced dwellings. But rather than rationing demand by raising rates, the Bank intends to choke off this demand through quantitative and qualitative restrictions.
The theory is straightforward; the practice is likely to be anything but. Rationing mortgage borrowing through quantitative controls will present the same financial and political problems as relying on interest rates. The Bank will have to find just the right combination of quantitative restrictions to stop excessive lending without stalling the housing market. While raising interest rates heaps pain on existing home owners, quantitative restrictions on lending will provoke a political backlash from first-time buyers who find themselves unable to buy a new home.
In theory, quantitative controls could enable the Bank to intervene in a much more targeted way. But that assumes the Bank can judge better than commercial lenders where credit is needed and will be used most wisely. It is a terribly Soviet-style way to allocate credit, and will expose the Bank to endless lobbying. Already Britain’s politicians are pushing the Bank to stimulate the flow of credit to small and medium-sized enterprises.
There are good reasons why policymakers in Britain, the U.S. and many of the other advanced economies gradually scaled back direct controls over the last 40 years. If it proceeds down this route, the Bank risks getting drawn into ever deeper interventions in the economy. Already it finds itself creating one distortion (artificially low interest rates) to offset another (the prolonged slump in output). Now it could have to create a second set of distortions (quantitative controls) to offset the problems caused by the first (cheap credit).
There is no clear exit strategy from these multiplying interventions. In encouraging a housing boom, the Bank risks repeating past errors. While policymakers are alive to the risk, they overestimate their ability to fine-tune the lending cycle.
Carney is obviously keen on literary references, so here is an even older one he and his colleagues on the Financial Policy Committee might like to bear in mind as they contemplate their shiny new macro-prudential controls, this one taken from the biblical book of Ecclesiastes: “The thing that hath been, it is that which shall be; and that which is done is that which shall be done; and there is no new thing under the sun.”
— John Kemp. Kemp is a Reuters market analyst. The views expressed are his own.