the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

TO BE NOTED: From Bloomberg:

"Yellen Signals Fed’s Decision to Let Lehman Fail Was a Mistake

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By Michael McKee and Vivien Lou Chen

April 17 (Bloomberg) -- Federal Reserve Bank of San Francisco President Janet Yellen signaled that it was a mistake to allow Lehman Brothers Holdings Inc. to collapse, saying the firm was “too big to fail” and its bankruptcy caused a “quantum” jump in the magnitude of the financial crisis.

The impact of Lehman’s failure “was devastating,” Yellen said yesterday after a speech in New York. “That’s when this crisis took a quantum leap up in terms of seriousness.”

Lehman was forced into bankruptcy on Sept. 15 after a weekend of negotiations at the Federal Reserve Bank of New York failed to produce a buyer and Fed and Treasury officials decided not to provide the firm with a loan.

Credit markets froze in the days after Lehman’s failure. Commercial paper markets almost ceased functioning as lenders shunned risk and the spread between the London Interbank Offered Rate, a measure of banks’ willingness to lend, and the average rate on overnight swaps rose 360 basis points in two weeks.

Yellen said she disagrees with Fed officials who argued in September that a government bailout of Lehman would encourage excessive risk-taking among investors. She commented in response to an audience question after a speech sponsored by the Levy Economics Institute of Bard College

“Lehman was a systemically important institution,” Yellen said, noting she was “sitting in California” at the time of Fed deliberations and “wasn’t involved in anything having to do with it.”

Yellen, echoing Fed Chairman Ben S. Bernanke and other federal regulators, said government officials need the authority to close down non-bank financial institutions.

‘Orderly Wind-Down’

Congress should “pass legislation that would provide for the orderly wind-down of a non-bank institution,” she said. “I’m sure it would have been used in the case of Lehman,” Yellen said, while declining to label the decision not to rescue Lehman an error.

Without a suitable “tool box,” Fed officials have been forced to improvise throughout the credit crisis.

“Bear Stearns, Lehman, AIG -- these have all been horrendous, miserable situations,” Yellen said. “We’re pushing the envelope of our powers, but we’re choosing to do that because the consequence of failing to do that seem unthinkable.”

Before joining the San Francisco Fed, Yellen served as a member of the Fed’s Board of Governors from 1994 to 1997. She left that post to become Chairman of the White House Council of Economic Advisers under former President Bill Clinton.

Policy Tools

Yellen also said she no longer opposes using the central bank’s policy tools to avert harmful asset-price bubbles similar to the one in U.S. housing this decade.

“Now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look,” she said in her speech. “What has become patently obvious is that not dealing with certain kinds of bubbles before they get big can have grave consequences.”

Yellen’s remarks make her at least the second Fed official after Gary Stern, of Minneapolis, to rethink the central bank’s hands-off approach toward bubbles, an article of faith during former Chairman Alan Greenspan’s 18-year tenure. The Fed’s low interest-rate targets between 2002 and 2004 were partly to blame for the easy credit and housing-price escalation that led to the current financial crisis, the San Francisco bank president said.

“I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles,” Yellen said in a speech at the conference. “However, recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy.”

Long-Held Ideas

While Yellen’s remarks are unlikely to result in immediate monetary-policy changes, they demonstrate how officials are questioning long-held ideas about the Fed’s role in markets. Yellen has led the San Francisco Fed since 2004.

A report yesterday showed that San Francisco Bay Area home prices fell a record 46 percent in March from a year earlier, the 16th month of declines.

Data released this week on employment and other areas of the economy suggest that the U.S. slump is easing. The reports buttress Bernanke’s assessment this week that the “sharp decline” in the economy appears to be moderating.

The economy, in areas such as home sales and consumer confidence, is showing “tentative signs” that the decline is slowing, Bernanke said in an April 14 speech in Atlanta. He added that “a leveling out of economic activity is the first step toward recovery.”

The central bank said in its Beige Book business survey on April 15 that the contraction slowed across several of the biggest regional economies last month, with some industries “stabilizing at a low level.”

“While we’ve seen some tentative signs of improvement in the economic data very recently, it’s still impossible to know how deep the contraction will ultimately be,” said Yellen, 62, who votes on rates this year."

little doubt that euphoria in some markets at some point will lead to a disconnect between fundamental values and current prices.

TO BE NOTED: From Antonio Fatas and Ilian Mihov on the Global Economy

"Bubbles and Systemic Risk

There is a wide-spread concern that the current monetary easing plants the seeds for the next bubble and therefore for the next financial meltdown. The logic is clear – between 2001 and 2004 Greenspan lowered interest rates to clean up the dot.com bust and as a result of the low interest rates a bubble in the housing market materialized. Over the past few months, Bernanke went well beyond Greenspan’s expansionary policy by lowering rates to 0%, by starting credit “defrosting“ programs as well as by implementing the so-called “quantitative easing”. The ultimate side effect of these efforts to resuscitate the economy must be again a bubble.

Whether a bubble will develop or not in the immediate future is not entirely clear. In this entry, however, I want to use these concerns in order to put up two topics for discussion: (1) Not all bubbles are the same; (2) The big issue is systemic risk – with or without bubbles.

1. Not all bubbles are born equal. The fact that a bubble may develop does not necessarily mean that we will get to the same catastrophic dynamics as in the past two years. Suppose that a bubble develops in the market for gold and the price goes to $3000 per ounce. At some point investors may realize that demand is faltering, they will start selling their holdings of gold and the bubble will deflate. Although for some investors the collapse of this bubble will generate uncomfortable redistribution of wealth, it is not going to lead necessarily to a financial meltdown. Even the dot.com bubble did not generate the same kind of dynamics as the ones we saw after 2007. The gold bubble and the dot.com bubble are very different from the house price bubble. In my view, the key distinction is whether the bursting of the bubble generates systemic risk for the banking sector. One of the fundamental reasons for the severity of the current recession is that credit markets froze because banks had too much uncertainty about their survival probability and they stopped lending. In plain words, the collapse of the bubble had implications for the entire economic and financial system. Not all bubbles have such effects.

Inevitably, there will be more bubbles in the future. There is little doubt that euphoria in some markets at some point will lead to a disconnect between fundamental values and current prices. Whether policy makers should address a bubble and by what means depends to a large degree on the risk of having an economy-wide meltdown once the bubble starts deflating.

2. From regulation to systemic risk policy? The dynamics of the vicious circle between the contraction of the real economy and the disintegration of the financial sector is reminiscent of the dynamics that led to the severity of the Great Depression. Roosevelt arrested these dynamics by implementing four policy changes: (1) financial restructuring (after the banking holiday); (2) expansionary monetary policy (allowed by the suspension of the gold standard); (3) fiscal expansion (i.e. the New Deal; I know that it had a small contribution to the recovery, but at least fiscal policy was not in the way of other policies); (4) regulatory changes (the Glass-Steagall act, etc.). Since the start of the toxic interaction between the financial collapse and the real economy contraction after the collapse of Lehman brothers, I have argued that policy makers have to act in the same four dimensions in order to stabilize the economic activity. This is hardly an original thought, but it is useful to remember that these were also the actions of the Roosevelt government.

At an event organized by INSEAD on April 3, 2009, I made the same argument and in a panel discussion after my presentation, Sir Andrew Large – a former Deputy Governor of the Bank of England – suggested that there is a fifth item that should be added to this list: policy related to systemic risk.

So far systemic risk has been in the realm of regulation. We can think of various restrictions on lending, leverage, capital adequacy ratios, etc., which are designed to minimize the risk of a system-wide collapse. The point of Sir Andrew Large was that these are static measures, but given the sharp increase in financial innovation and the rapid changes in financial markets, shouldn’t we think of a policy body that continuously reviews and changes some of these ratios on a dynamic basis? In the way that monetary policy changes interest rates, the new policy authority will have a set of instruments to deal with developments that raise systemic risk in the economy. Naturally, this body will be in charge of addressing bubbles that have systemic implications. However, it will not be just a bubble-buster, since systemic risk can arise even in periods without bubbles.

There are certainly pros and cons in implementing such a dramatic institutional change and I am sure that I do not do justice here to the ideas of Sir Andrew Large. But I think that this is a very original idea and it deserves further consideration.


Ilian Mihov

Posted at 2:05 AM "

It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt

TO BE NOTED: From the WSJ:

"By STEVEN GJERSTAD and VERNON L. SMITH

Bubbles have been frequent in economic history, and they occur in the laboratories of experimental economics under conditions which -- when first studied in the 1980s -- were considered so transparent that bubbles would not be observed.

We economists were wrong: Even when traders in an asset market know the value of the asset, bubbles form dependably. Bubbles can arise when some agents buy not on fundamental value, but on price trend or momentum. If momentum traders have more liquidity, they can sustain a bubble longer.

But what sparks bubbles? Why does one large asset bubble -- like our dot-com bubble -- do no damage to the financial system while another one leads to its collapse? Key characteristics of housing markets -- momentum trading, liquidity, price-tier movements, and high-margin purchases -- combine to provide a fairly complete, simple description of the housing bubble collapse, and how it engulfed the financial system and then the wider economy.

In just the past 40 years there were two other housing bubbles, with peaks in 1979 and 1989, but the largest one in U.S. history started in 1997, probably sparked by rising household income that began in 1992 combined with the elimination in 1997 of taxes on residential capital gains up to $500,000. Rising values in an asset market draw investor attention; the early stages of the housing bubble had this usual, self-reinforcing feature.

The 2001 recession might have ended the bubble, but the Federal Reserve decided to pursue an unusually expansionary monetary policy in order to counteract the downturn. When the Fed increased liquidity, money naturally flowed to the fastest expanding sector. Both the Clinton and Bush administrations aggressively pursued the goal of expanding homeownership, so credit standards eroded. Lenders and the investment banks that securitized mortgages used rising home prices to justify loans to buyers with limited assets and income. Rating agencies accepted the hypothesis of ever rising home values, gave large portions of each security issue an investment-grade rating, and investors gobbled them up.

But housing expenditures in the U.S. and most of the developed world have historically taken about 30% of household income. If housing prices more than double in a seven-year period without a commensurate increase in income, eventually something has to give. When subprime lending, the interest-only adjustable-rate mortgage (ARM), and the negative-equity option ARM were no longer able to sustain the flow of new buyers, the inevitable crash could no longer be delayed.

The price decline started in 2006. Then policies designed to promote the American dream instead produced a nightmare. Trillions of dollars of mortgages, written to buyers with slender equity, started a wave of delinquencies and defaults. Borrowers' losses were limited to their small down payments; hence, the lion's share of the losses was transmitted into the financial system and it collapsed.

During the 1976-79 and 1986-89 housing price bubbles, the effective federal-funds interest rate was rising while housing prices rose: The Federal Reserve, "leaning against the wind," helped mitigate the bubbles. In January 2001, however, after four years with average inflation-adjusted house price increases of 7.2% per year (about 6% above trend for the past 80 years), the Fed started to decrease the fed-funds rate. By December 2001, the rate had been reduced to its lowest level since 1962. In 2002 the average fed-funds rate was lower than in any year since the 1958 recession. In 2003 and 2004 the average fed-funds rates were lower than in any year since 1955 when the rate series began.

Monetary policy, mortgage finance, relaxed lending standards, and tax-free capital gains provided astonishing economic stimulus: Mortgage loan originations increased an average of 56% per year for three years -- from $1.05 trillion in 2000 to $3.95 trillion in 2003!

By the time the Federal Reserve began to slowly raise the fed-funds rate in May 2004, the Case-Shiller 20-city composite index had increased 15.4% during the previous 12 months. Yet the housing portion of the CPI for those same 12 months rose only 2.4%.

How could this happen? In 1983, the Bureau of Labor Statistics began to use rental equivalence for homeowner-occupied units instead of direct home-ownership costs. Between 1983 and 1996, the price-to-rental ratio increased from 19.0 to 20.2, so the change had little effect on measured inflation: The CPI underestimated inflation by about 0.1 percentage point per year during this period. Between 1999 and 2006, the price-to-rent ratio shot up from 20.8 to 32.3.

With home price increases out of the CPI and the price-to-rent ratio rapidly increasing, an important component of inflation remained outside the index. In 2004 alone, the price-rent ratio increased 12.3%. Inflation for that year was underestimated by 2.9 percentage points (since "owners' equivalent rent" is about 23% of the CPI). If home-ownership costs were included in the CPI, inflation would have been 6.2% instead of 3.3%.

With nominal interest rates around 6% and inflation around 6%, the real interest rate was near zero, so household borrowing took off. As measured by the Case-Shiller 10 city index, the accumulated inflation in home-ownership costs between January 1999 and June 2006 was 151%, but the CPI measured a mere 23% increase. As the Federal Reserve monitored inflation in the early part of this decade, home-price increases were no longer visible in the CPI, so the lax monetary policy continued. Even after the Fed began to slowly raise the fed-funds rate in May 2004, the average rate remained low and the bubble continued to inflate for two more years.

The unraveling of the bubble is in many ways the most fascinating part of the story, and the most painful reality we are now experiencing. The median price of existing homes had fallen from $230,000 in July to $217,300 in November 2006. By the beginning of 2007, in 17 of the 20 cities in the Case-Shiller index, prices were falling. Serious price declines had not yet begun, but the warning signs were there for alert observers.

Kate Kelly, writing in this newspaper (Dec. 14, 2007), tells the story of how Goldman Sachs avoided the fate of many of the other investment banks that packaged mortgages into securities. Goldman loaded up on the Markit ABX index of credit default swaps between early December 2006 and late February 2007, as their price dropped from 97.70 on Dec. 4 to under 64 by Feb. 27. But the market was not yet in free-fall: The insurance on AAA-rated parts of the mortgage-backed securities (MBS) remained inexpensive. By mid-summer 2007, concern spread to the AAA-rated tranches of MBS.

At the end of February 2007, the cost of $10 million of insurance on the AAA-rated portion of a mortgage-backed security was still only $68,000 plus a $9,000 annual premium. Housing-market conditions deteriorated further in the first half of 2007. Case-Shiller tiered price sequences in Los Angeles, San Francisco, San Diego and Miami all show serious declines by the summer of 2007. Prices in the low-price tier in San Francisco were down almost 13% from their peak by July 2007; in San Diego they were off 10% by July 2007. Startling developments began to unfold that month. Between July 9 and Aug. 3, 2007, the cost of insuring AAA MBS tranches went from $50,000 upfront plus a $9,000 annual premium for $10 million of insurance to over $900,000 upfront (plus the annual premium).

Once the cost of insuring new mortgage-backed securities skyrocketed, mortgage financing from MBS rapidly declined. Subprime originations plummeted from $160 billion in the third quarter of 2006 to $28 billion in the third quarter of 2007. Mortgage-backed security issuance fell comparably, from $483 billion in all of 2006 to only $30.7 billion in the third quarter of 2007. Other measures of new loan originations were falling at the same time. The liquidity that generated the housing market bubble was evaporating.

Trouble quickly spread from the cost of insuring mortgage-backed securities to problems with credit markets generally, as the spread between short-term U.S. Treasury debt and the LIBOR rate increased to 2.40% from 0.44% between Aug. 8 and Aug. 20, 2007. Since U.S. Treasury debt is generally considered secure, but a bank's loans to another bank carry some risk of default, the spread between these rates serves as an indicator of perceived risk in financial markets.

In one city after another, prices of homes in the low-price tier appreciated the most and then fell the most; prices in the high-priced tier appreciated least and fell the least. The price index graphs for Los Angeles, San Francisco, San Diego and Miami show that in all of these cities, prices in the low-price tier have fallen between 50% and 57%. Moreover, housing prices have continually declined in every market in the Case-Shiller index. According to First American CoreLogic, 10.5 million households had negative or near negative equity in December 2008. When housing prices turned down, many borrowers with low income and few assets other than their slender home equity faced foreclosure. The remaining losses had to be absorbed by the financial system. Consequently, the financial system has suffered a blow unlike anything since the Great Depression, and the source is the weak financial position of the people holding declining assets.

Earlier, during the downturn in the equities market between December 1999 and September 2002, approximately $10 trillion of equity was erased. But a measure of financial system performance, the Keefe, Bruyette, & Woods BKX index of financial firms, fell less than 6% during that period. In the current downturn, the value of residential real estate has fallen by approximately $3 trillion, but the BKX index has now fallen 75% from its peak of January 2007. The financial sector has been devastated in this crisis, whereas it was almost completely unaffected by the downturn in the equities market early in this decade.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury.

In an important paper in 1983, Ben Bernanke argued that during the Depression, severe damage to the financial system impeded its ability to perform its economic role of lending to households for durable goods consumption and to firms for production and trade. We are seeing this process playing out now as loan funds for automobile purchases have withered. Auto sales fell 41% between February 2008 and February 2009. Retail and labor markets too are now part of the collateral damage from the housing debacle. Housing peaked in early 2006. Losses from the mortgage market began to infect the financial system in 2006; asset prices in that sector began to decline at the end of 2006. Meanwhile, equities and the broader economy were performing well, but as the financial sector deteriorated, its problems blindsided the rest of the economy.

The events of the past 10 years have an eerie similarity to the period leading up to the Great Depression. Total mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44 billion in 1929. In 1920, residential mortgage debt was 10.2% of household wealth; by 1929, it was 27.2% of household wealth.

The Great Depression has been attributed to excessive speculation on Wall Street, especially between the spring of 1927 and the fall of 1929. Had the difficulties of the banking system been caused by losses on brokers' loans for margin purchases in 1929, the results should have been felt in the banks immediately after the stock market crash. But the banking system did not show serious strains until the fall of 1930.

Bank earnings reached a record $729 million in 1929. Yet bank exposures to real estate were substantial; as the decline in real estate prices accelerated, foreclosures wiped out banks by the thousands. Had the mounting difficulties of the banks and the final collapse of the banking system in the "Bank Holiday" in March 1933 been caused by contraction of the money supply, as Milton Friedman and Anna Schwartz argued, then the massive injections of liquidity over the past 18 months should have averted the collapse of the financial market during this current crisis.

The causes of the Great Depression need more study, but the claims that losses on stock-market speculation and a monetary contraction caused the decline of the banking system both seem inadequate. It appears that both the Great Depression and the current crisis had their origins in excessive consumer debt -- especially mortgage debt -- that was transmitted into the financial sector during a sharp downturn.

What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.

Mr. Gjerstad is a visiting research associate at Chapman University. Mr. Smith is a professor of economics at Chapman University and the 2002 Nobel Laureate in Economics."

deregulation eroded the Federal Reserve's power to stabilise the economy

From Free Exchange:

"Hamstrung Fed?

Posted by:

Economist.com | WASHINGTON

Categories:

Monetary policy

KEVIN DRUM links to a piece by the Nation's William Greider on how deregulation eroded the Federal Reserve's power to stabilise the economy. Mr Greider writes:

When deregulation began nearly thirty years ago, some leading Fed governors, including [Paul] Volcker, were aware that it would weaken the Fed's hand, and they grumbled privately. The 1980 repeal of interest-rate limits meant the central bank would have to apply the brakes longer and harder to get any response from credit markets. "The only restraining influence you have left is interest rates," one influential governor complained to me, "restraint that works ultimately by bankrupting the customer."

....The central bank was undermined more gravely by further deregulation, which encouraged the migration of lending functions from traditional bank loans to market securities, like the bundled mortgage securities that are now rotten assets....In 1977 commercial banks held 56 percent of all financial assets. By 2007 the banking share had fallen to 24 percent.

The shrinkage meant the Fed was trying to control credit through a much smaller base of lending institutions. It failed utterly.

Not long ago, in the pages of the Wall Street Journal, Alan Greenspan wrote along similar lines. After suggesting that it was the global savings glut which depressed long-term mortgage rates that caused the housing bubble (and not the Fed) he said:

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.

The solution is improvements in regulatory practice, according to Mr Greenspan. But both Mr Greenspan and Mr Greider seem to be of the opinion that the Fed was powerless in this respect. Earlier this week, my colleague disagreed with this assessment:

There was, of course, an alternative between letting the bubble inflate and inviting recession. Had Mr Greenspan and his colleagues concluded housing prices were too high and there was value in taming them, they could have used regulatory tools instead of monetary policy. They could have insisted on a margin requirement for home purchases—no one could put down less than 20% unless they obtained mortgage insurance. (At the peak of the bubble, the widespread use of second liens made 100% loan-to-value mortgages without insurance commonplace.) This would have been politically difficult since it would have deprived lots of people the opportunity to own a home, in violation of America’s credo. It would have also contradicted Mr Greenspan’s own deregulatory impulses. He resisted raising margin requirements on stocks in the 1990s in part out of a conviction that only small investors would be affected; big sophisticated players would find a way around them.

Mr Greider recommends that the regulatory system be widened to include the shadow banking system, but the shadow banking system arose in order to skirt regulatory limits—to lever up more effectively. Mr Greenspan also wants us to put in place a regulatory system which, "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", but it's difficult to imagine what such a perfect system might look like. Financial players live to get around the rules and increase leverage. Given enough time, financial tools will develop to accomplish this goal.

Assuming we're comfortable with an independent and powerful Fed, I think the necessary changes are much more modest. The Federal Reserve has explicit policy goals—price stability, low unemployment. It's a safe bet that a president wouldn't nominate someone for the position of Fed chairman who believed the Fed shouldn't interfere in the economy to achieve those goals. And yet, multiple presidents had no problem nominating an Ayn Rand acolyte with a visceral distaste for regulatory interference to the chairmanship.

Regulations ought to be flexible; as Mr Greider rightly notes, the capital requirements necessary amid a boom are quite different from those necessary during a crisis. The Fed should be charged with limiting financial leverage and systemic risk, and should have some flexibility in achieving these goals (as it has flexibility in tweaking the economy's money supply). Then we won't have non-interventionists in an explicitly interventionist position, and Fed chairmen won't have the luxury of shrugging off dangerous imbalances as someone else's problem."

Me:

Don the libertarian Democrat wrote:

March 20, 2009 20:49

I know that this is going nowhere so far, but I like the idea of a guaranteed/narrow banking sector, as opposed to a self-insured/supervised/no government guarantees investment sector.

The Fed using rates to slow the whole economy or issuing warnings doesn't seem viable, and, you're correct, the rules of investment are made to be broken. I'm not advocating this, just describing reality. I just can't see the Fed slowing the economy on a theory, or regulators being one step ahead of investors. I think that time travel is more viable than both of those eventualities.

"The recent surge in the market for US government bonds has several characteristics of a classic bubble."

I mentioned recently that it was pretty funny how we're reading quite a bit about stopping bubbles, while a Treasury Bubble might be right in front of people's eyes and they're missing it. Via Alia, from the FT:

"Another bubble is brewing – bonds

By Edward Chancellor

Published: January 4 2009 18:27 | Last updated: January 4 2009 18:27

Central bankers around the world have promised to pay more attention to the dangers posed by asset price bubbles. Yet they seem unable to refrain from inflating new ones. The recent surge in the market for US government bonds has several characteristics of a classic bubble.( I AGREE )

A bubble is defined by extreme overvaluation. Ten-year Treasuries with yields at half-century lows meet this description. The current yield of little more than 2 per cent provides no protection against the return of inflation any time over the next decade. In normal times, there would be no argument that Treasuries are overpriced( I AGREE ). These are not normal times, however.

Another essential attribute of a bubble is that it should be sold with a great story. A decade ago, overblown expectations for internet commerce fuelled the technology boom.

Today’s great hype is deflation( I AGREE ). Tales of global recession and collapsing financial markets are embroidered with lurid narratives from the 1930s and Japan in the 1990s. This bubble is motivated by fear( YES. THE FLIGHT TO SAFETY. ) rather than greed. Investors are seeking to protect themselves against deflation and declining stock markets by blindly acquiring “risk-free”( GOVERNMENT GUARANTEED ) government bonds.

The behaviour of institutional investors also contributes to the bond bubble. Pension funds, insurers and others have sold off toxic securitised triple-A rated bonds and replaced them with Treasuries. Government bonds are also attractive for diversification purposes since they have held up while just about everything else in their investment portfolios has collapsed. Many of the more sophisticated bond bulls are playing a “greater fool” game. Like dotcom speculators of the late 1990s, they know there is a danger the market will sell off at some time in the future. Nevertheless, they are staying for the ride and hope to bail out before it is too late( THIS EXPLAINS WHY BUBBLES LAST SO LONG ).

A common feature of great bubbles is that they enjoy the support of the authorities. In 1720, the public acquired shares in the South Sea Company secure in the knowledge that the bubble was promoted by the government of the day.

Today’s bond buyers place their faith in Ben Bernanke. The Fed chairman has long made it clear he sees low long-term rates as a tool for combating deflation. In December, the Fed announced it was considering purchasing government bonds. Just as the “Greenspan put” emboldened stock speculators a decade ago, the “Bernanke put” has placed an apparent floor under the market for Treasuries.( TRUE )

The deflation story that drives the current bond bubble is more plausible than the dotcom pipe-dreams of yesteryear. Deflation is sparked by a combination of bank losses and tighter lending standards, increasing risk aversion( THE MAIN CAUSE ) and a rise in the demand for money, falling household consumption and higher savings, together with mounting unemployment and a widening output gap. All these conditions pertain today. If this crisis were left to its own devices, the result would likely be a pronounced and prolonged decline in the price level as occurred in the early 1930s.( I AGREE )

However, the authorities are not standing by idly. Instead, the Fed is bolstering the credit markets in numerous ways and has cut short-term rates to near zero. Some $7,200bn (£4,930bn, €5,150bn) has been pledged to support the US financial system, of which $2,600bn has already been spent. Although bank lending is currently stagnant, the monetary base climbed by 775 per cent in the year to November.

Broader monetary aggregates are also expanding. The St Louis Fed’s MZM measure climbed 11.2 per cent over the past year. Nor is there evidence of widespread deflation in the economy. Although, the consumer price index has started to fall, only transportation has showed a pronounced decline( TRUE ). There is also the fiscal response to consider. Morgan Stanley projects that in 2009 the gross US fiscal deficit, including asset purchases from the private sector, will exceed 10 per cent of GDP.

Mr Bernanke gained his moniker “Helicopter Ben” after his famous November 2002 speech in which he outlined the various ways by which the authorities could combat deflation. “The US government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices of those goods and services,” stated the former Princeton economist and future Fed chairman.( I WISH HE'D MOVE FASTER )

“We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Investors who purchase long-dated Treasuries at current prices are betting that a determined man with the dollar printing press will fail in his battle against deflation.( IT'S A BAD BET )

Edward Chancellor is a member of GMO’s asset allocation team"

"the Fed would begin to tighten monetary policy using conventional means

Mark Thoma with another Regulator Approach to stopping bubbles:

"My proposal along these lines( HOW LONG WILL THIS LINE GET? ) (which I am not firmly attached to, just thinking about the implications) is to add a stock price index, s, to the the standard Taylor rule involving output, y, and inflation, p. Thus, the federal funds rate would be set according to ff* = a + b(y-y*) + c(p-p*) + d(s-s*), where * indicates the target value, and then conventional open market operations would be used to hit the federal funds rate target. Thus, whenever stock prices begin drifting above the targeted rate of growth( REGULATOR ), the Fed would begin to tighten monetary policy using conventional means ( THIS IS TOO BLUNT AN INSTRUMENT. YOU'RE CHOKING OFF GROWTH OUT OF FEAR OF A BUBBLE. SAD. ) (ideally, the index s is broad based and constructed with optimal weights rather than being a narrow, value-weighted index like the S&P 500, update: also, the notation is sloppy, but I mean the rate of change in s, "the targeted rate of growth," not the level). The proposal from Roger Farmer, however, is a bit different than this in that it has the Fed controlling the index directly through the "buying and selling blocks of shares on the open market," something I didn't highlight enough in the discussion linked above. With the augmented Taylor rule approach, there is no need to buy and sell stocks, something I think is an advantage. But there can be advantages to direct control as well, e.g. there would be more variation in s under the Taylor rule approach than there would be if s were stabilized directly through buying and selling blocks of shares, so if stabilization of s is an important policy goal, direct control may be preferred."

Here we go.

"After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble."

Peter Coy on Business Week with a post I like:

"This is war. On Dec. 16, the Federal Reserve announced it was stepping up what amounts to a shock-and-awe campaign against the most dangerous economic downturn in decades. In an unprecedented move, the Fed cut its short-term interest rate target to essentially zero while committing to buy mortgage bonds and other assets on a massive scale. The goal: to provide cheaper credit to every part of the economy, starting with housing.

Fed Chairman Ben Bernanke initially underestimated the fast-moving crisis( TRUE ), but now he's deadly serious( TRUE ). As a student of the Great Depression, Bernanke does not want to go down in history as the Fed chairman who allowed the U.S.—and possibly the world—to slip into the worst slump since the 1930s( CORRECT ).

Will the new battle plan work? Most likely yes—eventually ( I AGREE ). The Fed's monetary weaponry, in combination with the fiscal artillery of the incoming Obama Administration, are so potent that if they are used to their full extent they can almost certainly generate an economic recovery, potentially starting in the second half of 2009 ( I AGREE ). The problem is that today's all-out attack on recession may well generate a surge of unwanted inflation in 2010 or after( A VERY REAL POSSIBILITY ). But the Fed seems to regard that as an acceptable price to pay to avoid disaster now ( IT IS ).

True, the Fed has finally reached the end of the line on cutting rates—they can't go below zero. But it remains essentially unlimited in how much it can stimulate the housing market and broader economy by buying up mortgage-backed securities, Fannie Mae (FMN) and Freddie Mac (FRE) corporate debt, and other assets ( TRUE ). The Fed's early efforts are already showing some success( TRUE ). Since it said in late November that it would buy such securities, 30-year mortgage rates have fallen to 5.2% from 6%, and refinance applications have more than tripled. The Dec. 16 announcement will greatly( MODESTLY ) expand these purchases.

What's more, starting in early 2009, the Fed will pump money into markets for student, auto, credit-card, and small-business loans in hopes of helping those parts of the economy. All told, the Fed's assets—a measure of how much the Fed has lent, directly and indirectly—could go as high as $5 trillion, says Ed Yardeni of Yardeni Research. That's up from $2.2 trillion now. And the range of assets the Fed is permitted to acquire in an emergency is almost unlimited( VERY TRUE ). "It could buy a herd of cattle in Texas if it so desired," says Paul Ashworth, senior economist in the Toronto office of consultant Capital Economics.

These moves are so sweeping that they almost overshadow what would ordinarily be the biggest news of all: the Fed's Dec. 16 cut in its target federal funds rate to a range from zero up to 0.25%, the lowest in its history. The funds rate is what banks charge each other for loans to meet reserve requirements. In fact, the Fed's target had become irrelevant in recent weeks because what banks actually charge each other for those loans had already fallen to almost zero ( TRUE ). That's because of the huge surplus of reserves that the Fed has injected into the financial system( TRUE ).

Critics of the Fed say the central bank is running unacceptable( ACCEPTABLE ) risks of losses by itself and ultimately by taxpayers while propping up an unsustainable reliance on debt. "It's 100% wrong. It's going to make the situation worse," says Peter Schiff of Euro Pacific Capital, a brokerage in Darien, Conn. "In the short run, it does postpone some of the pain, but the economy is going to be in worse shape a year from now. Eventually we will have hyperinflation, where the dollar loses almost all its value( THAT'S THE FEAR )."

That, however, is a minority view. Most economists think that inflation is the last thing the Fed needs to worry about right now( THEY SHOULD WORRY ABOUT IT ). According to New York University economist Mark L. Gertler, who collaborated with Bernanke on research during the Fed chief's Princeton years: "We are in an incredibly dangerous situation. Now is the time to be aggressive. There's no danger of inflation. It's almost insane that people are talking about it now." Even with all the Fed's heroic measures, predicts Merrill Lynch (MER) senior economist Drew Matus, "the recession is going to be a long one, and the recovery is not going to be a big one( WHO KNOWS? )."

One reason for optimism—mild optimism, anyway—is that Bernanke has learned from the mistakes committed by the Fed during the Depression and the Bank of Japan during that nation's Lost Decade of the 1990s. In 1999, when he could afford to be undiplomatic, Bernanke asked in a book he contributed to whether Japan's monetary policy was "a case of self-induced paralysis," and he praised President Franklin D. Roosevelt's "willingness to be aggressive and to experiment."

When the economy does begin to recover, perhaps in the second half of 2009 or possibly later, the Fed will have a very different problem on its hands: how to soak up all of the excess liquidity it has created so it doesn't stoke inflation or some new asset bubble ( TRUE ). In a Dec. 17 research note, Yardeni wrote: "After one bubble bursts, the only way to get out of the resulting recession, and to avoid a depression, is to create another bubble( SORT OF )." That's not what anyone wants, but it's certainly better than the alternative—a downturn that would rival the Great Depression( I AGREE ).

Coy is BusinessWeek's Economics editor.

“Asset prices are a symptom. The underlying problem is excess credit growth.”

Can Central Banks stop bubbles? On Bloomberg, here's Caroline Baum:

"Dec. 11 (Bloomberg) -- Central banks care about financial stability.

Asset bubbles can be financially destabilizing.

Therefore, central banks care about asset bubbles.

If only policy makers found this syllogism persuasive.

Until now, central bankers pretty much cared about asset bubbles only to the extent that asset prices affected their ability to deliver price stability and, in the case of the Federal Reserve’s dual mandate, maximum employment. Otherwise, the operative doctrine was laissez-faire-’til-after-they-burst.

That’s about to change, said William White, who recently retired from the Bank for International Settlements, where he was economic adviser and head of the Monetary and Economic Department from 1995 to June 2008.

“The most calamitous downturns were not preceded by any degree of inflation,” White said in a telephone interview yesterday. “There was no inflation in 1873-74, in the 1920s, in the 1980s in Japan and in the 1990s in Southeast Asia.”

All these extended credit cycles ended badly. The U.S. economy contracted for 65 months, a record, from 1873 to 1879.

The bursting of the housing bubble and the deepening financial and economic crisis should be sobering to those who resist the idea that asset bubbles, when they burst, can be as destabilizing as inflation, which is the reason central bankers adopted inflation targets."

This is a pretty straightforward plan. Since Bubbles need easy credit or low interest rates for an extended period of time, don't let that happen. Central Banks can stop this by raising interest rates preventively.

"Central banks are still holding the line, at least publicly, on the inappropriateness of “targeting” asset prices, which misrepresents the issue. (More on that later.) Federal Reserve Vice Chairman Don Kohn said in a speech last month that he had reexamined the evidence and had came to the conclusion that he agrees with Alan Greenspan, his former boss and long-time advocate of bubble mop-up.

Bank of England policy makers are equally dug in, with Andrew Sentance, Charlie Bean and Sir John Gieve all arguing in recent speeches that using monetary policy, or interest rates, to “lean against the wind” is inadequate or inappropriate.

All these arguments miss the point. No one is suggesting central bankers target asset prices (Dow 13,000?). Nor is the issue bubble detection or identification, which implies policy makers know the appropriate level for asset prices and inspires visions of Sherlock Holmes-like characters looking under rocks in the hopes of making a discovery.

Economics is a social science. Econometric models spit out results that lack the accuracy of chemistry experiments and the precision of mathematical equations."

I was going to argue that this plan was a Mechanistic Plan, when she surprised me by agreeing with me about such models.

"Central bankers are forced to deal in the realm of the touchy-feely all the time. If their work could be reduced to an equation, we wouldn’t a) need them or b) find ourselves in the mess we’re in now. So why is it so hard for policy makers to grasp what White and his BIS colleagues have been saying for a decade?

“Targeting asset prices is not at all what we’ve been suggesting,” White said. “Asset prices are a symptom. The underlying problem is excess credit growth.”

Too much effort goes into differentiating this asset bubble from the rest: what White calls “the school of what’s different: the CDOs, CDO-squareds, the SIVs, the rating agencies.”

It makes more sense to focus on “the school of what’s the same, and that’s the credit cycle. There’s always something new, but there’s always something the same: leverage, speculation, declining credit standards,” he said."

He says that the problems are:

1) Leverage ( True )

2) Speculation ( True, but less important than 1 and 3 )

3) Declining Credit Standards ( True )

I would add:

4) Fraud, etc.

5) Government Incompetence

I also agree that it's not the new products, but disagree strongly about the Credit Ratings Agencies.

"Cracks are starting to appear in the asset-bubble-resistance facade. Questioned about a change in approach at an Oct. 15 speech, Fed chief Ben Bernanke said policy makers would have “to look very hard at that issue and what can be done about it.” He said it was unclear whether monetary policy or regulation and supervision was the proper tool.

Until now, there has been a persuasive argument for a hands- off approach to asset bubbles.

“Is it possible to lean against the upturn, or is it preferable to wait and clean up afterwards?” White said. “The models say you can wait. And it always worked. That’s a pretty powerful argument.”

The counter argument is that models aren’t always reliable. What worked in the past may not work now.

If the recession proves to be longer, deeper and more intractable than recent slumps, central bankers may come to appreciate the merits of leaning versus cleaning. Leaning may entail both “macroprudential instruments,” such as raising reserve requirements, capital requirements and loan-to-value ratios, and a “monetary instrument,” White said."

So, he suggests:

1) Raising Reserve Requirements ( Fine )

2) Raising Capital Requirements ( Fine )

3) Raising Loan-to-Value Requirements ( Fine )

4 ) A Monetary Instrument ( Not Sure )

"Cleaning appeared to have worked in the past, following the 1987 stock market crash, the early 1990s recovery from the savings and loan crisis in the U.S., and the late 1990s Asian financial crisis and near-collapse of Long-Term Capital Management. But “it works at the expense of making it worse next time around,” White said.

Cleansing, not cleaning, is what’s really needed. Without it, central banks have to “use a monetary instrument that is ever more aggressive” and will eventually cease to work, he said.

The best medicine, as with most things, may be an ounce of prevention.

“When you see a combination of rapid credit growth, a rapid rise in asset prices across a broad spectrum and changes in spending behavior, it should be a wake-up call that says: We have a problem,” White said.

Central bankers should realize that a lack of action during the credit upswing may impose greater costs to society.

“The facts are so obvious,” White said. “You don’t need to be a rocket scientist. Even an economist, when he sees something happen, will admit it is possible.”

If we see:

1) Rapid Credit Growth

2) Rapid Growth In Asset Prices

3) Changes In Spending Behavior

We should be worried.

I agree, but still find that using interest rates might be very harmful to businesses not participating in this rise, and a very blunt instrument. However, as a marginal tool, I wouldn't have a problem with it. But he conveniently left out the details of what he's calling for. I'm assuming that the blunt instrument argument is blunted by the bubble problem being a general problem, and so not limited to certain sectors, and pointing out that the bursting of the bubble has consequences for the entire economy.

It still seems to me that we need a better handle on how this mechanism actually influences people's behavior before we really commit to it.