Get Ready for the Next Financial Bubble

Investors are snapping up deeply risky investments. It may be only a matter of time until the market crashes again.

  Uh-oh: A problem waiting to happen. Uh-oh: A problem waiting to happen.  
National Journal
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Catherine Hollander
March 14, 2013, 4:10 p.m.

If the fin­an­cial crisis taught us any­thing, it was how badly a big burst bubble (in this case, over­val­ued mort­gage debt) can soak the eco­nomy. Les­son learned: Avoid bubbles! But the next one may be in­flat­ing already. The Fed­er­al Re­serve’s quant­it­at­ive-eas­ing pro­gram — in which it buys bonds, pump­ing money in­to the bank­ing sys­tem but lower­ing the re­turn on tra­di­tion­ally safe products — has pushed in­vestors else­where. They are rush­ing in­to the stock mar­ket and so-called junk bonds (which have low marks from rat­ing firms and of­fer high­er re­turns to com­pensate for their risk­i­ness), and poli­cy­makers have done little to stop them. “We are see­ing a fairly sig­ni­fic­ant pat­tern of reach­ing-for-yield be­ha­vi­or,” Jeremy Stein, a Har­vard eco­nom­ist and one of the Fed’s new­est gov­ernors, said in a speech last month, re­fer­ring to the prac­tice of tak­ing on risky in­vest­ments that could reap great­er-than-av­er­age re­wards.

“Reach­ing for yield” can lead to a bubble, which oc­curs when an as­set be­comes un­moored from its fun­da­ment­al value. It’s a product of psy­cho­logy: More people pile in­to a cer­tain type of in­vest­ment, be­liev­ing that prices will con­tin­ue rising; and, for a time, they do. (Such be­ha­vi­or is par­tic­u­larly likely when in­terest rates are low, as they are today be­cause the Fed has kept its bench­mark rate near zero since 2008 in an ef­fort to jump-start the eco­nomy.) But at some point, the bubble bursts, and prices plum­met as in­vestors flee. The dot-com bubble of the 1990s is an­oth­er re­cent ex­ample.

Once, the Fed didn’t think it could fight these trends with in­terest-rate hikes. In the late 1990s and early 2000s, there was a be­lief — ar­tic­u­lated by Ben Bernanke, then a Prin­ceton pro­fess­or, and Fed Chair­man Alan Green­span — that mon­et­ary policy was the wrong tool for stop­ping as­set bubbles. Fed of­fi­cials thought “safe pop­ping” was im­possible. Bet­ter to wield the cent­ral bank’s reg­u­lat­ory and su­per­vis­ory tools to en­sure the fin­an­cial sys­tem’s sta­bil­ity, and to use its mon­et­ary-policy tools to mop up after a bubble burst.

One reas­on eco­nom­ists thought mon­et­ary policy couldn’t pop bubbles is that they are very dif­fi­cult to spot. Bubbles of­ten rest on some real im­prove­ment in the qual­ity of as­sets, so know­ing just how much to “lean against” (that is, tight­en policy to de­flate) a bubble is tricky. Per­haps high-enough in­terest rates might de­ter in­vestors, but these would in­flict large-scale harm on the eco­nomy — the same out­come that bubble-prick­ing hopes to avoid, Green­span poin­ted out in 2002. Or maybe high­er rates wouldn’t de­ter in­vestors at all, giv­en the out­sized re­turns they ex­pect from their in­vest­ments dur­ing a bubble.

Still, the hous­ing crisis caused plenty of soul-search­ing at the cent­ral bank. The risks of a bubble might be too great for of­fi­cials to simply ig­nore them and hope for the best. In 2011, after five tu­mul­tu­ous years run­ning the Fed, Bernanke said that the cent­ral bank could no longer con­sider con­duct­ing mon­et­ary policy its chief re­spons­ib­il­ity; en­sur­ing fin­an­cial sta­bil­ity was just as im­port­ant, and mon­et­ary policy just might have a role in ad­van­cing it. This Janu­ary, he said that while mon­et­ary policy wasn’t “the first line of de­fense” against as­set bubbles — he’d still prefer to use reg­u­lat­ory and su­per­vis­ory power to shore up the fin­an­cial sys­tem — “if ne­ces­sary, we will ad­just mon­et­ary policy as well” to ad­dress the threat of a bubble.

Now the worry about an as­set bubble is rising. Days be­fore Bernanke made those re­marks at the Uni­versity of Michigan, Es­th­er George, pres­id­ent of the Fed­er­al Re­serve Bank of Kan­sas City and a vot­ing mem­ber of the cent­ral bank’s policy-set­ting com­mit­tee, noted in a speech, “Prices of as­sets such as bonds, ag­ri­cul­tur­al land, and high-yield and lever­aged loans are at his­tor­ic­ally high levels.” George voted against con­tinu­ing the Fed’s easy policies at the Janu­ary meet­ing, cit­ing the risk of a bubble. Stein gave his widely read speech on cred­it mar­kets just over a week later. And at an event hos­ted by The At­lantic on Wed­nes­day, former Fed Chair­man Paul Vol­ck­er said that too much quant­it­at­ive eas­ing could en­cour­age “spec­u­lat­ive activ­ity un­der­min­ing the very pro­cess of restor­ing sus­tain­able growth and fin­an­cial sta­bil­ity.”

Bernanke has dis­missed the con­cerns so far as in­suf­fi­cient to raise in­terest rates or to put an end to the Fed’s large-scale quant­it­at­ive eas­ing. “Al­though a long peri­od of low rates could en­cour­age ex­cess­ive risk-tak­ing, and con­tin­ued close at­ten­tion to such de­vel­op­ments is cer­tainly war­ran­ted, to this point we do not see the po­ten­tial costs of the in­creased risk-tak­ing in some fin­an­cial mar­kets as out­weigh­ing the be­ne­fits of pro­mot­ing a stronger eco­nom­ic re­cov­ery and more-rap­id job cre­ation,” the chair­man said in con­gres­sion­al testi­mony last month. Be­cause risk-tak­ing is part of a healthy eco­nomy, clamp­ing down on it too soon could stunt growth, he im­plied.

A num­ber of eco­nom­ists agree that the risks ap­pear con­tained at the mo­ment. “The stock mar­ket is prob­ably get­ting a little car­ried away, but not a lot,” says Nar­im­an Behravesh, chief eco­nom­ist at IHS Glob­al In­sight. Cor­por­ate earn­ings are strength­en­ing, after all, as is the broad­er eco­nomy. And low long-term yields aren’t ne­ces­sar­ily cre­at­ing a bubble in the bond mar­ket, Joseph Gagnon, a seni­or fel­low at the Peterson In­sti­tute for In­ter­na­tion­al Eco­nom­ics, said in testi­mony be­fore a House Fin­an­cial Ser­vices sub­com­mit­tee last week, so long as they re­flect ex­pect­a­tions about the path of in­terest rates set by the Fed and sup­por­ted by its hold­ings of long-term se­cur­it­ies. These one-hand, oth­er-hand mus­ings are pretty typ­ic­al of the de­bate over bubbles — that is, un­til they burst.