How the Federal Reserve Can Avoid the Next Bubble

The central bank needs to watch asset prices and raise rates quickly when it decides the time is right.

From the Wall Street Journal

By IAN BREMMER AND NOURIEL ROUBINI

Ben Bernanke and the Federal Reserve face a number of very difficult challenges in the years ahead. They include:

• Resisting pressure to monetize deficits, which would eventually cause high inflation.

• Implementing an exit strategy from the massive monetary easing of the past year.

• Maintaining the Fed's independence, which has been compromised by the direct and indirect bailout of financial institutions and congressional attempts to micromanage the central bank.

• Properly calculating asset prices and the risk of asset bubbles according to the Taylor rule, an important guideline central banks use to set interest rates.

• Supervising and regulating the financial system more effectively, particularly in the role of "systemic risk" regulator.

The first two tasks are closely related. In order to prevent a persistent monetization of deficits that would lead to inflation, the Fed must implement an exit strategy from the unconventional monetary easing that began in late 2008. If the fiscal and monetary stimulus is taken away too soon, there is the risk of relapsing into deflation. If it is taken away too late, we may eventually face a fiscal crisis and an inflationary recession, or stagflation.

The Fed does not control fiscal policy. But to avoid a game of chicken wherein loose fiscal policy forces the Fed to monetize deficits to prevent a spike in bond yields, the Fed needs to pre-emptively state it won't be buying more Treasury bills.

As for the exit from monetary easing, the Fed must learn from the fateful mistake it made after the 2001 recession. Then, the central bank cut the federal-funds rate too much and kept it too low for too long. It also moved far too slowly when the normalization occurred—in small increments of 0.25% from summer 2004 until the summer of 2006, when it peaked at 5.25%. Normalization took two full years. It was in that period of slow normalization that the housing, mortgage and credit bubbles spiraled out of control. The lesson learned: When you normalize, move rapidly, or prepare for another dangerous bubble.

Of course, this is easier said than done. From 2002 to 2006, the Fed moved slowly because the recovery appeared anemic and because of significant deflationary pressures. This time around, the recession is more severe—unemployment is at 9.8% and is expected to peak above 10%, and we are experiencing actual deflation. Therefore, the incentive not to exit too soon will be greater and the risk of creating another bubble is greater. Indeed, the sharp increase in the stock market and commodities, and narrowing of credit spreads since March, are partly due to a wall of global liquidity chasing assets and already causing asset inflation.

If the conflict between economic growth and financial stability requires that monetary policy remain loose, then it is critical that the supervisors and regulators of the banking sector move aggressively to prevent another bubble from emerging. Thus they should quickly adopt the regulatory reforms agreed to by the G-20—including a new insolvency regime for financial institutions deemed "too big to fail," a serious approach to limiting "systemic risk," and appropriate rules governing incentives and compensation for bankers and traders.

It won't be easy to define systemic regulation and too-big-to-fail. There is a significant risk that doing so will provide an implicit guarantee for large and complex financial institutions. There is also a longer-term risk that actions taken by congressional and regulatory agencies will distort global financial markets. Western financial institutions now depend heavily on state financial backing, and several governments have tweaked rules and regulations to support the large financial institutions that are now at least partially taxpayer-owned. Further, governments could increasingly require domestic financial institutions to lend more at home, which will curtail their foreign operations. Creating a system of effective financial regulation—while resisting the impulse to favor domestic institutions—will be a real challenge for most countries, including the U.S.

Over time, once the fed-funds rate is normalized, incorporating asset prices into monetary policy making is also necessary to ensure financial stability. While it is correct that the fed-funds rates may not be the most effective instrument at controlling asset and credit bubbles, excessively cheap money is always a source of such bubbles. So faster normalization of the fed-funds rate will eventually be important.

The Fed's involvement in quasi-fiscal operations creates other challenges. As long as the Fed remains involved in maintaining financial stability and in preventing other episodes of systemic risk, it will be hard to eliminate the perception that the Fed will be involved as a lender of last resort for too-big-to-fail firms. So far, this Pandora's Box remains open.

The way to prevent future moral-hazard distortions is to create a regulatory regime where too-big-to-fail institutions have much higher capital requirements: a greater liquidity buffer, lower leverage, and lower involvement in risky and illiquid investments if they are depository banks. They should be supervised internationally and must be able to be closed down in an orderly fashion should failure loom.

The Fed is currently resisting a Treasury-led effort to review how it is organized out of concern it might forfeit its independence. Yet the governance structure of the New York and other regional Federal Reserve banks left them effectively controlled by large financial institutions last year, so such a review is necessary. While congressional interference in the Fed's jurisdiction is a danger, the recent quasi-fiscal activities of the Fed bear a review.

The Fed also needs a greater regulatory backbone. The Fed had the power to regulate mortgage markets but failed to use this power out of a misplaced deference to laissez-faire attitudes and Wall Street. Regulating mortgage markets requires a careful balance: short-term regulatory forbearance to avoid a greater credit crunch, along with medium-term countercyclical supervisory actions in order to prevent the emergence of further asset and credit bubbles.

Establishing financial stability—in addition to price stability and growth—is the essential role of the central bank. Achieving this goal in a way that avoids moral-hazard distortions, as with the too-big-to-fail finance institutions, and prevents another bubble in the next years will surely be one of the greatest challenges ever faced by the Fed.

Mr. Bremmer, president of Eurasia Group, is co-author of the "The Fat Tail: The Power of Political Knowledge for Strategic Investing" (Oxford University Press, 2009). Mr. Roubini is a professor of economics at New York University's Stern School of Business and chairman of RGE Monitor.

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Alan Greenspan Defends Himself On Bubbles

In the article--The Fed Didn't Cause the Housing Bubble--Alan Greenspan defends himself. No doubt this makes for interesting reading. And, equally interesting conclusions.

How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.

If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

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The Fed Didn't Cause the Housing Bubble

Any new regulations should help direct savings toward productive investments.

By ALAN GREENSPAN

We are in the midst of a global crisis that will unquestionably rank as the most virulent since the 1930s. It will eventually subside and pass into history. But how the interacting and reinforcing causes and effects of this severe contraction are interpreted will shape the reconfiguration of our currently disabled global financial system.

There are at least two broad and competing explanations of the origins of this crisis. The first is that the "easy money" policies of the Federal Reserve produced the U.S. housing bubble that is at the core of today's financial mess.

The second, and far more credible, explanation agrees that it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages. Between 2002 and 2005, home mortgage rates led U.S. home price change by 11 months. This correlation between home prices and mortgage rates was highly significant, and a far better indicator of rising home prices than the fed-funds rate.

This should not come as a surprise. After all, the prices of long-lived assets have always been determined by discounting the flow of income (or imputed services) by interest rates of the same maturities as the life of the asset. No one, to my knowledge, employs overnight interest rates -- such as the fed-funds rate -- to determine the capitalization rate of real estate, whether it be an office building or a single-family residence.

The Federal Reserve became acutely aware of the disconnect between monetary policy and mortgage rates when the latter failed to respond as expected to the Fed tightening in mid-2004. Moreover, the data show that home mortgage rates had become gradually decoupled from monetary policy even earlier -- in the wake of the emergence, beginning around the turn of this century, of a well arbitraged global market for long-term debt instruments.

U.S. mortgage rates' linkage to short-term U.S. rates had been close for decades. Between 1971 and 2002, the fed-funds rate and the mortgage rate moved in lockstep. The correlation between them was a tight 0.85. Between 2002 and 2005, however, the correlation diminished to insignificance.

As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.

That decline in long-term interest rates across a wide spectrum of countries statistically explains, and is the most likely major cause of, real-estate capitalization rates that declined and converged across the globe, resulting in the global housing price bubble. (The U.S. price bubble was at, or below, the median according to the International Monetary Fund.) By 2006, long-term interest rates and the home mortgage rates driven by them, for all developed and the main developing economies, had declined to single digits -- I believe for the first time ever. I would have thought that the weight of such evidence would lead to wide support for this as a global explanation of the current crisis.

However, starting in mid-2007, history began to be rewritten, in large part by my good friend and former colleague, Stanford University Professor John Taylor, with whom I have rarely disagreed. Yet writing in these pages last month, Mr. Taylor unequivocally claimed that had the Federal Reserve from 2003-2005 kept short-term interest rates at the levels implied by his "Taylor Rule," "it would have prevented this housing boom and bust. "This notion has been cited and repeated so often that it has taken on the aura of conventional wisdom.

Aside from the inappropriate use of short-term rates to explain the value of long-term assets, his statistical indictment of Federal Reserve policy in the period 2003-2005 fails to address the aforementioned extraordinary structural developments in the global economy. His statistical analysis carries empirical relationships of earlier decades into the most recent period where they no longer apply.

Moreover, while I believe the "Taylor Rule" is a useful first approximation to the path of monetary policy, its parameters and predictions derive from model structures that have been consistently unable to anticipate the onset of recessions or financial crises. Counterfactuals from such flawed structures cannot form the sole basis for successful policy analysis or advice, with or without the benefit of hindsight.

Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind."

How much does it matter whether the bubble was caused by inappropriate monetary policy, over which policy makers have control, or broader global forces over which their control is limited? A great deal.

If it is monetary policy that is at fault, then that can be corrected in the future, at least in principle. If, however, we are dealing with global forces beyond the control of domestic monetary policy makers, as I strongly suspect is the case, then we are facing a broader issue.

Global market competition and integration in goods, services and finance have brought unprecedented gains in material well being. But the growth path of highly competitive markets is cyclical. And on rare occasions it can break down, with consequences such as those we are currently experiencing. It is now very clear that the levels of complexity to which market practitioners at the height of their euphoria tried to push risk-management techniques and products were too much for even the most sophisticated market players to handle properly and prudently.

However, the appropriate policy response is not to bridle financial intermediation with heavy regulation. That would stifle important advances in finance that enhance standards of living. Remember, prior to the crisis, the U.S. economy exhibited an impressive degree of productivity advance. To achieve that with a modest level of combined domestic and borrowed foreign savings (our current account deficit) was a measure of our financial system's precrisis success. The solutions for the financial-market failures revealed by the crisis are higher capital requirements and a wider prosecution of fraud -- not increased micromanagement by government entities.

Any new regulations should improve the ability of financial institutions to effectively direct a nation's savings into the most productive capital investments. Much regulation fails that test, and is often costly and counterproductive. Adequate capital and collateral requirements can address the weaknesses that the crisis has unearthed. Such requirements will not be overly intrusive, and thus will not interfere unduly in private-sector business decisions.

If we are to retain a dynamic world economy capable of producing prosperity and future sustainable growth, we cannot rely on governments to intermediate saving and investment flows. Our challenge in the months ahead will be to install a regulatory regime that will ensure responsible risk management on the part of financial institutions, while encouraging them to continue taking the risks necessary and inherent in any successful market economy.

Mr. Greenspan, former chairman of the Federal Reserve, is president of Greenspan Associates LLC and author of "The Age of Turbulence: Adventures in a New World" (Penguin, 2007).

Bob DeMarco is a citizen journalist and twenty year Wall Street veteran. Bob has written more than 500 articles with more than 11,000 links to his work on the Internet. Content from All American Investor has been syndicated on Reuters, the Wall Street Journal, Fox News, Pluck, Blog Critics, and a growing list of newspaper websites. Bob is actively seeking syndication and writing assignments.

Bold Endeavors: How Our Government Built America, and Why It Must Rebuild Now

A Brief History of Stock Market Drops--the Last 80 years

Market Mayhem

There have been plenty of big selloffs in the stock market over the last month, but early on Friday Oct. 24, many market watchers thought it would bring the big one that would join other infamous days. For history's sake, however, the days since Lehman Brothers' chapter 11 have been momentous and notable enough. Here's a look at some very bad days and periods for stocks that got investors' attention over the past 80 years.

Crash of 1929
The stock market crash of 1929 saw the market fall 12.8 percent on Oct. 28, 1929, known as “Black Monday," but the market fell almost as sharply the day after. The crash contributed to the Great Depression of the 1930s and many also consider it part of a two-decade bear market.

1973-1974
During this period of the Nixon-Ford presidency, when inflation was a major concern because of the first oil spike, the Dow went from its Jan. 11, 1973 high of 1051.70 to a low of 577.60 on Dec. 6 1974, a 45.1 percent decline.

Oct. 19, 1987
Known as Black Monday, or "The Crash," the Dow fell 507.99 points, or 22.61 percent, as part of a broad global selloff.

Oct. 13, 1989
The failure of a leveraged buyout of airline holding company UAL triggered what was then known as the "Mini Crash." The Dow fell 190.58 points, a 6.91 percent decline.

1997
The financial crisis in Asia, primarily in South Korea, Indonesia and Thailand, had its largest impact on the US markets on Oct. 27, 1997 when the Dow dropped 554.26 points, 7.18 percent, forcing an early closing of the NYSE.

Dot-Com Bubble Burst
The tech sector was hit hard as the dot-com bubble burst. The Nasdaq peaked at 5048.62 on Mar. 10, 2000 before beginning a brutal two-month slide. By May 23, 2000, it was down 37.32 percent.

Sept. 17, 2001
The Dow dropped 684.81 points (7.12 percent) on Sept. 17, 2001, the Monday the New York Stock Exchange resumed trading for the first time after the 9/11 attacks.

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