An age-old debate was re-ignited last week, when the Organisation for Economic Cooperation and Development called for higher interest rates to rein in Australia's resurgent housing market.
Should central banks actively "lean" on asset bubbles by raising the cost of credit, or ignore asset prices and focus purely on hitting their inflation targets?
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'Not far off' a housing bubble and bank pain, says investor
International investors are wary of Aussie bank stocks because of the housing market's recent wobbles.
Today's combination of debt-fuelled rises in asset prices and low inflation means this question is as relevant as ever.
A new book on perhaps the best-known central banker in history, former US Federal Reserve chairman Alan Greenspan, makes a compelling case for central bankers being leaners.
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Sebastian Mallaby's biography of Greenspan, The Man Who Knew, challenges the conventional view that the US Fed chairman was effectively asleep at the wheel in the build-up to the global financial crisis.
Based on five years of research and extensive access to Greenspan, it provides new evidence the Fed chairman who presided over the sub-prime lending spree was indeed aware of the big risks posed by bubbles.
In an interview with BusinessDay, Mallaby said this awareness was evident in documents released under Freedom of Information laws, which reveal Greenspan and other Fed officials talking about the need for tougher regulation of sub-prime lending.
Greenspan's awareness of bubble risk was also evident in his comments about pressures building in the housing market in the 2000s during meetings of the Federal Open Market Committee, the body that sets US rates. Transcripts of its meetings are made public after five years.
In a deeper sense, the book traces Greenspan's understanding back decades earlier, when in his thirties, he wrote his thesis about financial instability and its huge threat to growth.
Yet as we all know, he didn't prevent the poor lending that led to the sub-prime crisis, one of the biggest bubbles ever.
"A lot of people say we had a crisis in 2008 because the financial system was overseen by people who were just naive about the risks. We had a bunch of laissez-faire believers in the efficiency of financial markets," says Mallaby.
However, he contends that's not right.
[Greenspan] was the man who knew, but he was not the man who acted.
Sebastian Mallaby
"Greenspan didn't believe in efficient markets, he understood that finance was dangerous, he wasn't naive about it at all. He was the man who knew, but he was not the man who acted," Mallaby says.
Why then, did Greenspan fail to act more decisively? And what lessons does this experience hold for central banks today?
Mallaby says a key reason Greenspan failed to act was politics. Trying to rein in risky lending meant dealing with a fragmented group of regulatory bodies, and taking on powerful vested interests in the finance sector.
For example, he says that in 2004 Greenspan was pushing to cap the size of US home lenders, Fannie May and Freddie Mac, which ultimately needed to be rescued by taxpayers four years later.
When the Fed's calls for action looked like being acted on by politicians, however, the lenders fought back with television ads that warned people would miss out on home ownership if their lending was restricted. The politicians backed away.
Given these political constraints, Mallaby argues central bankers should instead lean on bubbles with higher interest rates.
"I think that if you accept my argument that the Fed tried a bit to regulate the extremes of the risk, but politics got in the way ... then it seems to me that when an asset bubble is inflating then you probably ought to use a different tool to fight it, and that would be interest rates," he says.
Yet even today, after all the pain of the global financial crisis, many senior figures in finance don't agree.
Former Fed chairman Ben Bernanke has publicly argued that trying to lean on asset bubbles doesn't make sense because bubbles are notoriously hard to spot. Pricking them requires dragging the whole economy down. Better to clean up the mess later, the argument goes.
But how does this all relate to Australia?
Well, a key reason the OECD expects the Reserve Bank will raise interest rates next year will be to "unwind tensions from the low-interest environment, notably in the housing market".
It must be noted that our central bank and financial regulators don't have to deal with a political system anywhere near as dysfunctional as that of Washington DC. Nor am I in any way comparing our housing market with the sub-prime crisis.
But at the same time, our regulators have had limited success in cooling the market by imposing lending restrictions on banks.
Despite housing investor loan curbs announced in late 2014, Sydney house prices went up 13.1 per cent in the year to November, and over the past four years they are up about 60 per cent. Melbourne's annual prices growth has picked up to 11.3 per cent, or 40 per cent in the last four years.
And for what it's worth, the RBA's top brass have generally come down on the side of "leaning" when discussing this question in the past.
Former RBA governor Glenn Stevens said in 2012, presciently, that the mess left by bubbles was often so large that you couldn't simply clean it up with even more cheap debt.
Stevens' replacement, Philip Lowe, co-authored an influential paper in the early 2000s arguing central banks should be wary of allowing low interest rates to fuel asset-price booms, even though this was an unfashionable view at the time.
Mallaby's insights on Greenspan suggest Lowe and Stevens were right to err on the side of "leaning" in their public comments. If the OECD is correct, it could be a debate we hear more about in 2017.
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