Dec 27, 2013

After the Greenspan put: new market insurance

With the passage of far-reaching regulatory reforms following the 2008 financial crisis, there has matured a view in the policy circles that asset bubbles should be suppressed by targeted regulatory approaches, without resorting to contractionary monetary policy, that needlessly slows down the entire economy.

Indeed, in the past, the US has successfully employed tailored regulatory methods in limiting the buildup of bubbles. In the 1940s and 50s, for example, the government effectively suppressed excessive real estate price inflation by imposing more stringent loan underwriting standards. In another example, the Federal Reserve had increased margin requirements on stock purchases from 40% to 100% in order to restrain the unjustifiably rapid increase in stock market prices in 1945. While the stock market continued rising, the amount of stocks traded on margin was sharply reduced, hence taking some heat out of stock speculators.

Given some past successes with the targeted approach as a way to suppress of asset bubbles and the newly expanded regulatory powers of the Fed, a belief in the government is solidifying that, as Governor Sarah Raskin of the Fed Board of Governors put it, "While there could be situations in which monetary policy might be needed to try to limit the growth of a bubble, in my opinion such use would represent a failure of regulatory policy." (Raskin, 2013). In other words, from now on the Fed will not resort to tightening monetary policy as a way to limit excessive asset growth. What is left at the government's disposal are the so-called macroprudential tools.

Post the 2008 financial crisis, there has been a renewed interest in macroprudential policies that are specifically designed to restrain financial excesses. The following are some key macroprudential tools that the Fed can utilize to suppress a mounting asset bubble: (1) increase minimal capital requirements for financial institutions, (2) require greater liquidity levels, (3) raise margins on securities lending transactions, (4) impose stricter credit underwriting standards.

However, successful utilization of these tailored macroprudential tools requires the identification of excesses in the first place. Given that neither the Fed nor economists were able to predict the 2008 credit-fueled crisis, there is a high likelihood that the Fed will not be able to spot a credit bubble in the future, nor have the political power to contain it in time. In fact, when firms' profits are strong and high, regulators, just like market participants, are prone to believe that risks in the system are minimal, whereas in reality a credit boom might be growing to abnormal levels. Moreover, although financial regulation has improved in its comprehensiveness and scope, it still lacks the united coordination among regulatory bodies in order to swiftly orchestrate a targeted macroprudential strategy.

If, economic history is of any use to us, very LT investors, we would note that the real estate bubble of the 2000s "was the first major credit expansion since the creation of the Federal Reserve during which supervisors’ efforts to address credit growth were not backed by monetary policy, automatic stabilizers such as interest rate ceilings and usury laws, or more direct selective credit controls." (Elliott, 2013, p.38). That is, neither the monetary policy, nor macroprudential tools were utilized to constrain the crisis!

In his address to the National Association for Business Economics back in 2002, governor Ben Bernanke of the Fed, discussed monetary policy's harmful effects on the economy if it is used to pop asset bubbles, instead of combating inflation and unemployment. To prove his point, Bernanke provided a concrete historical example of how the Fed's tightening of the monetary policy in the late 1920s to suppress stock market speculation resulted in the Great Depression (Bernanke, 2002). Yet tighter monetary policy does have its benefits when employed, as it reduces overall risk taking in the economy, including in places macroprudential policy cannot reach, such as financial intermediation occurring in the shadow banking system (Adrian, Covitz, Liang, 2013). Bernanke added that the Fed should instead utilize macroprudential tools, such as capital requirements and stress testing, to manage credit bubbles. However, the Fed never resorted to these tools prior to the 2008 calamity. This highlights how backward American financial regulation and supervision was prior to the crisis, and the Fed was rightly "slapped in the face by the invisible hand" of free-market forces for its inaction (Gorton, 2009, p.2).

When the next major credit expansion takes places, and the Fed decides to use only targeted macroprudential tools to try to handle the credit growth and money intermediation in our highly interconnected and complex financial system, a very LT investor will be right to note that this action might not be enough to produce expected results. Since the Fed will forgo the usage of big guns, that is the monetary policy, in containing the next major euphoria, a very LT investor can expect to see the bubble growing to an unmanageable, crisis-prone size. The avoidance of monetary policy is the new protection, or the next generation of Greenspan-puts, for financial markets.

If the Fed is not going to resort to monetary policy to constrain a credit expansion, nor most likely will it be able to predict a looming bubble, nor use macroprudential tools to their full efficacy, given the fragmented regulatory system and the fact that the Fed is still calibrating these tools and learning how to employ them, nor even the usage of targeted tools is a guarantee that frenetic market participants will discontinue driving prices up, then what exactly is left at the government's disposal? A very LT investor can thus rest assured that in the next major credit expansion the Fed will not stand in the way of stock market bulls.


Sources

Adrian, T., Covitz, D., Liang, N. (2013). Financial Stability Monitoring. (Staff working paper in the Finance and Economics Discussion Series, # 2013-21). Federal Reserve Board, Washington, D.C.

Bernanke, B. (2002, October). Asset-Price "Bubbles" and Monetary Policy. Speech presented at the New York Chapter of the National Association for Business Economics, New York, NY.

Elliott, D., Feldberg, G., Lehnert, A. (2013). The History of Cyclical Macroprudential Policy in the United States. (Staff working paper in the Finance and Economics Discussion Series, # 2013-29). Federal Reserve Board, Washington, D.C.

Gorton, G. (2009). Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007. Paper prepared for the Federal Reserve Bank of Atlanta conference. Atlanta, GA.

Raskin, S. (2013, July). Beyond Capital: The Case for a Harmonized Response to Asset Bubbles. Speech presented at the Exchequer Club Luncheon, Washington, D.C.

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