Bubble Trouble

There are many things that can give financial markets jitters, but only a few do so with clockwork regularity. The United States Federal Reserve is such an entity, and its reputation for making the market quiver is well-earned. Shudders mainly occur when the Fed uses monetary policy to fulfill two often-contradictory tasks: minimize inflation and maximize employment. Historic mandate and conventional wisdom dictate that the Fed should keep to these tasks and these tasks alone. However, after the 2008 financial crisis turned much conventional wisdom into outright foolishness, policymakers have rightly ratcheted up their scrutiny of that mandate. Thanks to the Dodd-Frank Act passed after the crisis, financial stability has been officially added to the Fed’s regulatory mandate. This is encouraging but insufficient; long leery of moving beyond the axis of low inflation and high employment, the Fed must consider financial stability a first priority of monetary policy, too. In practice, this means that the Fed must be willing to prick asset bubbles.

Asset bubbles and financial stability are not easy to explain. The International Monetary Fund once produced an entire memo with the sole purpose of arriving at a workable definition of financial instability. But to paraphrase Chief Justice Potter Stewart’s definition of pornography, you know it when you don’t see it. That’s why former Federal Reserve Governor Roger Ferguson wrote, “it seems useful to define financial stability by defining its opposite: financial instability.” Ferguson links financial instability to several conditions, the most powerful of which are asset bubbles.

A technical but fair description of an asset bubble would be when “some important set of financial asset prices seem to have diverged sharply from fundamentals.” Fundamentals here mean level-headed and soberly calculated judgments of an asset’s actual worth. Asset bubbles occur when the price of some important asset class — like property, stocks, or bonds — untethers from reality and spirals up. During an asset bubble, investors buy and sell assets based on a value created by what Alan Greenspan called “irrational exuberance,” a misunderstanding of an asset’s inherent worth or stability.

While the core focus of monetary policy is straightforward, the tools the Fed employs to control the money supply range from the convoluted to the labyrinthine.

This suspension of disbelief accompanies the giddy contagiousness of asset bubbles. If all your friends are flipping houses and making a fortune doing so, you’d feel remiss if you didn’t get in on the action. It’s for this reason that asset bubbles are often associated with vast expansions of debt — as investors try to maximize their investment in an upwardly spiraling asset and thus their potential profit, they take out loans. When the bubble bursts, as it inevitably does, enormous amounts of wealth evaporate and creditors call in their debts. As was the case in 2008, the consequences of such an occasion can be grave — so grave that the Fed’s failure to incorporate asset bubble containment into its central mission seems negligent in retrospect.

For all its importance to the economic well-being of both Main Street and Wall Street, the Fed is an institution often misunderstood and shrouded in mystery. “Secrets of the Temple,” “The Wizard of the Fed,” and “The Creature from Jekyll Island” are just a few of the chillingly enigmatic titles of books on the Fed and its chairs. Public perception reflects the air of mysticism that veils the Fed; a 2014 Pew Research Poll found that more than three-quarters of those surveyed did not know whom the chair was. This ignorance is no surprise given the Fed’s secretive beginnings: The Federal Reserve Act of 1913, which established it, was the result of secret negotiations on a coastal island owned by a group of tycoons, including banker JP Morgan. The Fed’s birth was the result of a growing consensus that the United States needed a central authority that could act as a lender of last resort during financial panics. In practice, this meant lending money to financial institutions wobbling on the edge of failure when no one else would be willing to do so. Though originally created specifically to mitigate such incidents, the Fed’s role evolved over time such that it now claims sole responsibility for US monetary policy and much of the responsibility for the country’s financial regulatory policy.

In this way, the Fed adapted to do something utterly crucial for the US economy, yet shockingly simple: control the number of dollars in circulation. Of course, while the core focus of monetary policy is straightforward, the tools the Fed employs to control the money supply range from the convoluted to the labyrinthine. If the Fed sought to deflate an asset bubble with monetary policy, for example, it would decrease the number of dollars in the economy in order to restrict credit availability and reduce the amount that could be poured into investments in a bubbling asset. Regulatory policy consists of supervising banks as well as simply regulating them, and, in the aftermath of the 2008 crisis, these supervisory and regulatory powers were broadened such that the Fed now enjoys a role in managing so-called “systemic risk” in the financial system.

Historically speaking, these tools, especially monetary policy, were used to achieve two main objectives: minimizing inflation and maximizing employment. These goals were the North Star that guided the Fed’s direction while financial stability was more of a means than an end. In many ways, the Fed’s inception as a lender of last resort cast the mold for its approach to financial crises: It cleaned up after asset bubbles popped and panics emerged but rarely attempted to address the root forces that created these crises. The Fed was always the trauma surgeon in the ER but never the general practitioner at the annual checkup.

The advent of Dodd-Frank and its sweeping extension of the Fed’s mandate for supervising and regulating the financial system go some way toward fixing this. But it’s insufficient: If central banks, and the Fed in particular, are to properly ward off asset bubbles and ensure a respectable degree of financial stability, the Fed will need to direct monetary policy — not just regulation — toward this goal too.

For starters, regulation is an imperfect tool. It requires an intimate understanding of the banking sector — an industry known for its byzantine complexity and whirring innovation. Case in point: Much of the 2008 meltdown was driven by regulators’ failures to identify the dangers in firms’ reckless use of derivatives, which mixed bad mortgages in with good ones and were presented as low-risk products. Moreover, globalized finance means that firms, looking to engage in risky business, can take their business somewhere the regulations they’re looking to avoid don’t apply. American International Group (AIG), the company the US government nationalized out of fear that its failure would make the Lehman Brothers bankruptcy look like the liquidation of a lemonade stand, was toxic primarily because of a subsidiary that sold insurance for mortgage derivatives. Contrary to its name, AIG’s subsidiary carried out its operations in London — with a French banking license, no less. Reforms and greater regulatory coordination between countries in the wake of the financial crisis have softened the danger of such evasion, but it’s far from snuffed out.

Even the most nuanced regulations simply don’t exert the broad-based impact that interest rates and, by extension, monetary policy do. As Harvard Professor and previous member of the Federal Reserve Board of Governors Jeremy Stein put it, monetary policy “has one important advantage relative to supervision and regulation — namely that it gets in all the cracks.” Financial institutions can evade regulations, but not the interest rate. If the Fed wants its actions to be all-encompassing, monetary policy is the best route for accomplishing that.

The shortcomings of supervision and regulation aside, there are myriad other reasons monetary policy should busy itself with financial stability. Chief among these is the fact that one of the dragons that monetary policy has always been tasked with slaying — runaway inflation — simply isn’t the menace that it used to be. Inflation, as measured by the monthly consumer price index, hasn’t crept above 6 percent since 1990. There are many reasons for chronically low inflation, ranging from the decline of widespread union membership to the blistering pace of technological advances and more globalized trade. But if the economy is indeed less inflation prone now, as seems to be the case, then monetary policy should turn its mighty reach to other antagonists — specifically, financial instability. As Morgan Stanley’s head of global macro wrote of the Fed’s stated aims, “this job description is outdated, because the job is largely done.” This isn’t to say that monetary policy should completely ignore price changes; deflation, in which prices decline rather than increase, is the scourge that sends a shiver down the spines of central bankers the developed world over. But price stability should no longer be the unchallenged first priority for the Fed as it has been in the past.

Finally, when monetary policy ignores financial stability, as it has done in the past, there are deep and long-lasting drawbacks. This is largely due to the fact that monetary policy influences financial stability whether it intends to or not. When interest rates are low, earning high rates of return through investment gets a lot harder. As such, asset managers who are obliged to maintain a rate of return and earn a slice of their clients’ profits often start looking at riskier investments that pay higher returns. This behavior is known as “reaching for yield.” Some, like Governor of the Reserve Bank of India Raghuram Rajan, consider reaching for yield to be a structural problem occurring in times of security with low interest rates. Critically, this reaching means that there are more risky assets floating around the economy — like the noxious mortgage-backed securities in vogue just before the housing crisis — making financial crises themselves more likely to occur. In short, a low interest rate environment sows the seeds of its own demise. Rajan epitomized this wisdom in a 2005 speech later made famous by the financial crisis: “An unanticipated and persistent low interest rate can be a source of significant distortions for the financial sector, and thence asset prices.” Such a counter-culture claim was blockbuster stuff in the world of central bankers.

If it’s true that low interest rates can create the potential for excessive risk to build up in the financial system, it’s also true that they make loans much cheaper. But in addition, it means that general amounts of debt — particularly for private actors, like households and corporations — quickly accumulate. As long as there are no big economic shocks and business continues as usual, this is fine. But when there is an economic shock, such as the bursting of an asset bubble, large amounts of debt are extremely problematic. The 2008 financial crisis began with a housing bubble, and some think the recovery from said crisis has been particularly tepid because of high levels of household debt. After a crisis, overly indebted consumers will take time reducing their debt burdens; consequently, they are less liable to spend lots on movie tickets, restaurants, smart phones, and all the other widgets that make the world go ‘round. In the eloquent words of Paul Krugman, “it was debt what did it.” Not only do lingeringly low interest rates encourage risky investing that can lead to a crisis, but they also lengthen the impact of such crises by reducing an economy’s power to consumer-spend its way out of recession. With these dangers in mind, the Fed should avoid such extended low interest rate environments unless absolutely necessary.

Like any controversial proposal, putting the onus of financial stability on monetary policy is an imperfect solution. Prominent figures like former Chairman of the Federal Reserve Ben Bernanke have raised legitimate concerns over the bluntness of monetary policy as a tool and the possibility of adverse effects on the economy and employment. It’s true that the depth and breadth of monetary policy are reflected in its imprecision. Moreover, bubbles are difficult to diagnose, and a misdiagnosis would be costly in terms of jobs and economic growth. Nonetheless, the destructiveness of bubbles and contagiousness of financial instability in this day and age make these counterarguments persuasive only to the extent that policymakers should tread carefully, rather than not tread at all.

Targeting asset bubbles with monetary policy isn’t as difficult as skeptics make it out to be. Asset bubbles that pose a serious threat to the national economy — such as the housing bubble or the dot-com burst — usually come with warning signs. For example, while it may be hard to track the development of bubbles through asset prices alone, Stein has suggested that the Fed can monitor proxies, like the junk bond market, to get a sense of whether markets might be overvalued. “Overheating in the junk bond market might not be a major systemic concern in and of itself,” Stein said, “but it might indicate that similar overheating forces were at play in other parts of credit markets, out of our range of vision.”

Ultimately, the argument for monetary policy’s stake in financial stability comes down to two things: the limits of regulation and supervision and the fact that monetary policy is a powerful tool that affects financial stability and asset bubbles anyway. Dodd-Frank codified a much greater role for the Federal Reserve in ensuring financial stability; the Fed is now tasked with identifying and overseeing institutions that are “systemically risky,” with a view to preventing another Lehman Brothers meltdown. But its role in ensuring financial stability hasn’t gone deep enough yet. One of the first sections of the Federal Reserve Act lists the objectives for monetary policy: “maximum employment, stable prices, and moderate long-term interest rates.” Still, conspicuous by its absence is any mention of asset bubbles or financial stability. In order to face these threats, frequently far from the thoughts of central bankers, the Fed must climb out of its own bubble and put that realization in writing.