14. Back to the Future

As this is being written, the financial and economic crisis rages on. While progress has been made in quelling the panic in the financial system, it remains far from normal and the global economic downturn remains intense. The global economy will likely continue to shrink in 2009; the last time that occurred was during World War II. The subprime financial shock thus continues to reverberate.

Continued sharp declines in house prices are particularly unnerving. With no clear bottom in sight for the residential real-estate market, financial institutions remain unsure of their losses on mortgage loans and securities. Many have already written down their portfolios by large amounts, subtracting from their balance sheets both the estimated losses from defaults and declines in the market value of their remaining loans and securities. Some institutions believe that the market has grown overly pessimistic and that those securities will eventually rise again in value; thus, the write-downs might simply reflect a temporary hysteria from the subprime shock. Whether this ultimately proves correct depends on how far house prices eventually fall. Another wave of financial turmoil looms if house prices don’t soon find a bottom.

Also disconcerting is the fact that many banks don’t have the capital they need to withstand the credit losses that are still coming—even after the hundreds of billions of taxpayer dollars that have been put into them. The nation’s biggest banks will get what they need from taxpayers to survive, but hundreds of community and regional banks won’t and will be taken over by the FDIC as credit problems spread from residential mortgages to other types of lending. Never have there been so many auto repossessions, and credit card and student loan delinquencies are rising quickly. Banks also have loans out to troubled home builders and have sizable commercial loan portfolios that will soon face serious problems from weakening rents and falling commercial property prices.

Even with government help, the big banks will remain hobbled and unable or willing to extend the credit that businesses and households need to hire, invest, and spend. Until these institutions are able to work off the mountain of very troubled loans and securities on their balance sheet, they won’t have the wherewithal or inclination to provide the credit the economy needs to function well. The hope is that the banks can make significant progress in ridding themselves of these toxic assets in coming months, but it’s not difficult to imagine this taking years.

Parts of the global financial system that have held up reasonably well also could ultimately give way under future waves of the subprime shock. One likely candidate is the mammoth market for credit default swaps. Although CDS on mortgage-related securities are relatively well understood, a much larger portion of the market involves default swaps on corporate bonds. These have been unaffected thus far because corporate bonds have experienced relatively few credit problems. However, as corporate bond defaults rise, which they will, the default-swaps market will surely be tested. Work is being done to get CDS trading on exchanges so they can be monitored (CDS trading has been historically done over-the-counter and, thus, not on well-organized and regulated exchanges), forestalling a problem, but these efforts might not be enough.

Nervousness about the soundness of the banking system elsewhere in the world, particularly in Europe, is also well-founded. Many Western European banks, which are among the largest in the world, made big loans to Eastern European businesses, households, and banks. Many of these loans were in euros, which seemed like a deal when things were going well and euro interest rates were much lower than rates on credit denominated in Polish zlotys or Hungarian forints. As the financial crisis has gone global and there has been a flight-to-quality, Eastern European currencies have fallen sharply in value. Polish homeowners who have euro-denominated mortgages have seen their monthly payments in zlotys soar. A U.S.-style foreclosure problem could soon roil Eastern Europe. German, Austrian, and French banks that are struggling to digest their bad U.S. investments could choke on their Eastern European loans. The vortex engulfing the global financial system will grow wider and deeper.

Other potential new shocks could emerge as well, but it remains unclear which pose the greatest threats and to which institutions. Financial markets remain disturbingly opaque, making it hard for financial players to identify or prepare for additional threats. If financial institutions are worried and uncertain, they will remain cautious and will restrict credit and raise its cost for nearly everyone, good borrowers as well as bad. Until credit flows more freely and cheaply, the economy will not get its groove back.

Policymaking in the Crisis

The bad news is that the global financial and economic crisis is sure to be the most severe since the Great Depression. The good news is that what we are experiencing will be nothing like those times. That dark period lasted more than a decade, and U.S. unemployment topped out at 25%. Unemployment in this downturn could well reach into the double digits and the economy might not return to full employment—generally thought to be 5%—in President Obama’s first term, but this is far from the endless breadlines and mass exodus of homeless families we suffered during the 1930s.

Much was learned during that trying time, and many financial and economic safeguards were put in place to prevent such an occurrence from ever happening again. The Federal Reserve now knows that it must take extraordinary steps to forestall a deflationary cycle—in which falling prices and wages force businesses and households to pull back, causing prices and wages to fall even more—even printing trillions in dollars to buy those things no one else can or is willing to. Policymakers also know that putting up trade barriers and engaging in financial protectionism such as restricting cross-border investments result in the global tit-for-tat that undermines economies even more.

Many of the safeguards put in place during the Great Depression are working admirably now. The FDIC was born out of the ashes of the thousands of Depression-era bank failures, and the FDIC has forestalled bank runs and major failures during this crisis. Unemployed workers are getting unemployment insurance benefits, food stamps, and soon even help with COBRA payments to pay for their health insurance so that they don’t panic (along with everyone they know) because of their lost job. The unemployment insurance system was erected in response to the Great Depression.

The most fundamental lesson of the Great Depression for today’s crisis is that government must be extraordinarily aggressive. In normal times, government must be strong but little seen; in times of crisis, it must be overwhelming and everywhere. Policymakers working fast and taking big steps will make mistakes, even mistakes that can make matters worse. But with consumers, businesses, bankers, and investors panicked and pulling back, only government has the resources and the will to fill the resulting void.

Policymakers in the current crisis were slow to heed this lesson but have grown increasingly bold. Their actions now have become increasingly unconventional and even unprecedented. Yet their best efforts have not been able to end the turmoil—far from it. A prudent approach thus dictates that policymakers plan as if their current efforts will be insufficient to the task ahead and prepare for what to do next.

For the Federal Reserve, this could well mean that it will have to effectively become the nation’s financial system—the principal and, in some cases, only source of credit—at least for awhile. This requires printing trillions of dollars and using those dollars to purchase a wide array of assets, make loans to other financial institutions, and guarantee assets owned by other financial institutions. The Fed has aggressively stepped up its buying to include commercial paper issued by blue-chip companies and Fannie and Freddie’s debt and the mortgage securities they insure. They are even buying longer-term Treasury bonds—monetizing the nation’s debt, as they say. Buying corporate bonds and equity would be a stretch but could be necessary if businesses have difficulty funding themselves. The Bank of Japan has gone down this path. Although the Fed is prohibited from directly buying municipal securities, it would likely find a creative way to do so if municipalities were at risk of defaulting on their debts.

The Fed is also lending cheap money to hedge funds and other investors for purchases of financial securities backed by auto loans, credit cards, student loans, small business loans, and even residential and commercial mortgage loans. This Term Asset-Backed Securities Lending Facility (TALF) has the potential to restart frozen securities markets so that credit can resume flowing to consumers and businesses. To make it more effective, TALF might have to be expanded to include many other existing and lower-rated securities. Investors might also need assurances that if they participate in TALF and thus receive taxpayer-subsidized funds, they will not receive the kind of withering scrutiny and restrictions that other financial institutions receiving taxpayer help have received.

Teetering financial institutions could need the Fed to guarantee that the losses on their toxic assets don’t increase to the choking point. The Fed did this for Citigroup, Bank of America, and AIG, helping to forestall their collapse. This would be particularly important if other efforts to get the bad assets off institutions’ balance sheets, such as TALF, fall flat.

The Obama administration and Congress also need a Plan B and perhaps Plan C. The financial system will certainly require more taxpayer dollars to put it on a sound footing. The first dose of help via TARP cost taxpayers $700 billion. The second dose will cost at least that. The additional funds will be needed to fund the Treasury’s private-public bank, which, like the TALF, will provide cheap loans to hedge funds and other investor groups to buy, in this case, troubled loans that financial institutions own. However, even more than TALF, the private-public bank seems at risk of failing. Investor groups might have an appetite to buy securities that institutions have marked down to depressed market values due to mark-to-market accounting rules, but that appetite might not be there for loans whose values are determined by models and, thus, haven’t been marked down nearly as much. Unless the private-public bank is up and running by summer 2009, the Treasury could have no choice but to directly buy the bad loans. The political will has been lacking for this, given the worry that the Treasury will overpay for the loans, but it will cost taxpayers much more if the bad loans continue to fester and impair the ability of financial institutions to resume lending.

Another round of fiscal stimulus seems like a real possibility. The $100 billion in tax rebates mailed in summer 2008 proved less potent than hoped because much of the money was used to pay for record-high gasoline prices. The $800 billion stimulus that began working its way into the economy in spring 2009 might also not provide the economic pop needed. Although it’s big, it’s not big enough: The money will be spread out over more than two years, and the economy’s problems have only gotten worse since its passage. Stimulus 3, if needed, should be mostly temporary tax cuts. A payroll tax holiday for both employees and employers—say, during the first half of 2010—would be especially effective. This would be costly, about $450 billion, but it would be a significant cash infusion for strapped households and small businesses that will be out of cash by then. Temporary tax cuts don’t provide the same boost to jobs as, say, infrastructure spending, but the money can get into the economy much more quickly.

Given the failure of each successive policy attempt to promote work-outs between mortgage lenders and troubled homeowners from Hope Now and Project Lifeline to Hope for Homeowners, the current attempt in President Obama’s housing and foreclosure mitigation policies could also fall short. These efforts are being overwhelmed by the magnitude of the problem and the shifting forces behind it. When Hope Now was established in late 2007, the main driver of foreclosures seemed to be the prospect of huge interest-rate resets on subprime ARM loans. Yet this possibility faded as the Fed’s aggressive rate cuts drove down current interest rates: By the time their reset clocks ran out in early 2008, many subprime homeowners ended up facing no big jump in payments at all. Foreclosures have continued to increase, but now the biggest problems are negative homeowners’ equity and rising unemployment. Hope Now was not designed to tackle these issues, and Hope for Homeowners, which was designed for this, has turned out to be too complicated and too costly to get much participation by mortgage lenders. The administration has high hopes that its housing policy will forestall millions of foreclosures by modifying loans so that homeowners have much lower monthly payments. However, the policy does not reduce the negative equity homeowners are laboring under.

The next policy effort to forestall foreclosures should include loan modifications that reduce the mortgage principal underwater homeowners owe. Only when homeowners feel like they have a stake in their home will they work hard to make their mortgage payments. The criteria for being able to participate in such a modification should be strict, applying only to owner-occupying homeowners who were put into inherently unaffordable loans when they were originated. The monthly payments on these loans were too high from the start. These were loans that shouldn’t have been made, and regulators should have stopped them. Because they didn’t, taxpayers now arguably bear some responsibility to help. Even if taxpayers feel no such responsibility, it doesn’t make much economic sense for them to let these loans go through foreclosure. The foreclosures drive down house prices, making all homeowners less wealthy. Foreclosures also add to the financial system’s burden for exacerbating the credit crunch, resulting in more lost jobs and tax revenues. If troubled homeowners do not receive financial help, the costs to taxpayers will almost certainly be greater than the cost of bailing them out.

Preventing the Next Crisis

Policymakers understandably have had little room to consider how to ensure that something like this never happens again. The crisis hit its apex when the Bush presidency was winding down and the Obama presidency was getting off the ground. Both were very short-staffed at a time when an army of policymakers would have had an impossible time keeping up with events. But after the panic subsides and the crisis is quelled—and it will—policymakers must quickly refocus their attention to preventing the next crisis.

What follows is a “top ten” list of what I believe needs to be done, starting with the most pressing items and ending with the most complex. The list has changed a bit since the first edition of the book was released in fall 2008 because policymakers have already implemented a few of the suggestions. Most notable is the Federal Reserve’s adoption of clear guidelines for appropriate mortgage lending: Under the Fed’s new rules, lenders must consider the borrower’s ability to repay and also verify the borrower’s income and assets. Prepayment penalties are barred if a homeowner refinances within 60 days after an adjustable loan reset, and borrowers must establish escrow accounts for taxes and insurance. These common-sense lending rules apply to all mortgage lenders, given the Fed’s broad authority.¹

Policy Step #1: Modify Mark-to-Market Accounting

Past financial crises have often resulted from lax accounting rules. Ironically, the subprime financial shock is partly the result of too-rigid rules. Mark-to-market accounting standards, implemented widely in recent years, need to be adjusted. The rules put pressure on financial institutions to quickly adjust the book value of their assets to reflect market prices. The practice stems from the reasonable argument that it is better to deal with problems quickly and move on, even if the adjustment is painful. But what happens when institutions own assets whose prices can’t be found, or for which the market price reflects temporary panic? In the midst of the subprime shock, trading in the mortgage securities market literally froze. With no buyers, even Aaa-rated prices for these securities went into free-fall.

Of course, such a plunge could—and did—reflect weakening housing and mortgage markets, but depressed prices could also simply reflect fear and distressed selling. If so, these prices would eventually rebound, but not until after institutions marked down their assets. In the subprime shock, markdowns were so large and cut so deeply into some institutions’ capital that it threatened their survival.

To keep this from happening in the future, mark-to-market accounting rules could be tweaked most importantly for securities that financial institutions don’t ever plan on selling. These are known as held-to-maturity securities, and financial institutions—including all of the Federal Home Loan Banks and many depository institutions—hold hundreds of billions of them. If these institutions will hold on to these securities until they mature and their auditors think they will never be forced to sell them, why should they mark these securities to current market values? It is reasonable for institutions to value these securities based on expectations of any losses they might eventually suffer, but it isn’t reasonable to value these securities using prices they would get if they sold them today. Without some quick relief on this mark-to-market accounting rule, the FHLB system could soon be insolvent, putting an added unnecessary burden on taxpayers.

Policy Step #2: Reinstate the Uptick Rule

The downdraft in stock prices, particularly for financial institutions, has been dizzying. Much lower stock prices for these companies are surely justified, given the near-collapse of the financial system and the subsequent infusion of taxpayer capital, but there is a justifiable (albeit difficult-to-prove) concern that stock prices have been manipulated lower by short-sellers. Short-sellers borrow stock and sell it with the intent of buying back the stock in the future at a lower price. With financial stocks so vulnerable in this crisis, short-sellers often at least implicitly teamed up, borrowing and selling the stock and driving prices ever lower. Rumors—some perhaps true, but many that weren’t—often swirled as financial stocks were barraged by short-selling.

The uptick rule is an attempt to throw a bit of sand into a short-selling frenzy. With this rule, a short seller would be able to sell the stock only at a price above the price at which the immediately preceding sale was effected, or at the last sale price, if it is higher than the last different price. This rule had been in place since the Great Depression, when Joseph Kennedy, the first SEC commissioner instituted it; it was dropped in summer 2007, just about the time financial stock prices began heading south. The research done on the rules’ effect is inconclusive, but the logic for it seems compelling. The only downside to reinstating the uptick rule is a worry that it could reduce the number of transactions and, thus, liquidity, making it more difficult to come up with an accurate price for the stock. This concern seems stretched.

Policy Step #3: Expand Data Collection

A lack of timely and accurate information hobbled policymakers’ ability to respond to the subprime financial shock. Data on mortgage delinquencies and defaults comes from a variety of mostly private sources, making it nearly impossible for regulators or others to see the crisis as it grew. No government agency tracks the number of mortgage foreclosures, for example, and the various private sources of such information are limited in various ways.

A ready mechanism for expanding the government’s data collection already exists under the data-collection efforts required by the Home Mortgage Disclosure Act (HMDA). HMDA requires most mortgage originators to report some information on all loan applications and approvals. This includes data on the lender, location, income, and ethnicity of the borrower; whether the loan is a first or second lien; whether it is a purchase loan or refinancing; and the loan’s amount and interest rate.

Reporting requirements should be expanded to include mortgage servicers, who, in most cases, are also the lenders already reporting under HMDA. Servicers can provide information on delinquencies and defaults, as well as information on whether various types of loans and borrowers are having credit problems. Reporting under HMDA should be more frequent—it currently occurs annually—and data releases should be accelerated. The HMDA data for 2006 wasn’t fully released until fall 2007. More frequent updates and more rapid reporting would help policymakers and lenders spot credit quality problems earlier and allow them to respond better to developing problems.

Policy Step #4: Reform the Fractured Foreclosure Process

The current mortgage foreclosure system is a complex mélange of laws and rules that varies substantially from state to state. The foreclosure process generally entails three steps: first a loan default, no more than six months after the first missed loan payment; then a fore-closure auction; and finally a sale of the property by the bank. The average time between the first and last steps ranges from about 7 months in Virginia to 20 months in New York City.

The federal government streamlined the bankruptcy code in 2005 to make it more uniform across states, and it should do the same for foreclosures. A federal foreclosure system would substantially reduce the cost of the foreclosure process, be more equitable to borrowers and lenders, and allow for the more accurate collection of data and information.

A federal foreclosure process should standardize the time between a mortgage loan default and an auction. One year would be reasonable because that is approximately the median current length of time among states. A year would be sufficient to give borrowers who have hit hard times—perhaps because of unemployment or illness—a meaningful opportunity to work with their lenders and turn things around. It also allows lenders to foreclose within a reasonable time if borrowers are unable or unwilling to meet their obligations.

A federal process should also favor the nonjudicial form of foreclosure. This is a change in my thinking, given the current mess in states with judicial foreclosures. The Florida courts, for example, have been woefully inadequate in handling the state’s tsunami of foreclosures. At first the courts let a massive backlog of cases develop, and then they worked through the backlog so quickly that distraught homeowners failed to get any hearing at all. Deficiency judgments, which hold borrowers liable for the difference between the price a home fetches in a foreclosure sale and the amount of outstanding debt,² should be severely restricted, as should the right of redemption, which gives the original homeowner a chance to repurchase a foreclosed home for up to a year after it is auctioned. This right can add delay and uncertainty to the process and reduce the value of the foreclosed home. A one-year period between default and foreclosure offers homeowners sufficient time to negotiate with lenders or to find the cash to keep their homes, if they are able.

Policy Step #5: Invest in Financial Literacy

Americans aren’t as smart about money as we should be. Financial illiteracy was a fundamental cause of the subprime financial shock. Yes, many people knowingly stretched to buy an expensive home with a subprime ARM loan, figuring they could either sell quickly at a profit or refinance before the payment reset hit. But many more barely understood what they were getting into. According to Federal Reserve surveys done before the subprime shock, almost half of lower-income home buyers (mostly subprime) couldn’t describe basic features of their mortgage, such as how their interest rate was determined or whether it was capped. Many trusted their brokers to get them a mortgage they could afford, believing it was the broker’s responsibility to look after their financial interests.

The nation’s general financial illiteracy contributes to a wide range of poor decisions on borrowing, saving, and investing. This might have been less dangerous 10 or 25 years ago, when there were fewer financial products to choose from and it was harder to make a financially catastrophic mistake. But ignorance of the basics is certainly perilous today. Some of the mortgage options presented to home buyers during the housing boom were mind-numbingly complex and confusing; even an economist adept at manipulating spreadsheets would have had trouble calculating future payments on an interest-only or “option” ARM loan.

It is both bizarre and tragic that American high schools today are more likely to offer students cooking classes than personal finance courses. Such courses should be required—period. A meaningful investment in the financial acumen of young people would pay enormous dividends by reducing the likelihood that future households will take out bad mortgages or not save adequately for retirement.

Policy Step #6: Raise Financial Transparency and Accountability

Both transparency and accountability are vital to a well-functioning financial system. Both were thought to be present until the subprime financial shock occurred.

Transparency means timely, meaningful, reliable, and complete information is available regarding financial products, institutions, and markets. In transparent markets, financial players borrow, lend, and buy and sell aggressively. In opaque markets, players are uncertain and tend to panic in times of trouble, just as they did during the subprime shock.

Financial products were anything but transparent. Complex mortgage loans were offered to home buyers, and nearly incomprehensible mortgage securities were sold to investors. Too many financial institutions hid in the shadows and outside the regulatory light. Large global banks took on risks that they kept off their books until forced to take responsibility. No one really knows what most hedge funds are up to. At times it was all but impossible to reasonably price most mortgage securities. Even the integrity of the LIBOR interest rate, a daily financial benchmark used to calculate financial costs all over the world, has been called into question.

Accountability means someone is ultimately responsible if mistakes are made. No one bore responsibility for the performance of mortgage loans made during the housing boom; as a result, many bad loans were made. The mortgage securities market remains in disrepair partially because it is unclear how to apportion responsibility for the performance of the underlying loans. Someone must have enough financial skin in the game to want to be sure that good loans are originated and securitized.

Ensuring transparency and accountability requires confident regulatory oversight, which, in turn, must be empowered by Congress and the executive branch. Now that the Federal Reserve has explicitly backstopped the broker-dealer industry via its new credit facilities and its resolution of the Bear Stearns collapse, the quid pro quo should be a more watchful and questioning eye on that industry’s capital and activities. This will also provide a better window into the hedge fund industry. In addition, the SEC must become more aggressive about policing financial statements, audit opinions, credit ratings, and analyst reports.

A balance must be struck between the benefits of transparency and accountability and the costs of greater disclosure by financial players. The subprime shock showed how unbalanced things have become. Regulators must set it right.

Policy Step #7: Fix Securitization, Don’t Scrap It

The process of securitization clearly broke down during the housing boom and bubble. The originate-to-distribute model, in which lenders made a loan they quickly sold to investment bankers, who packaged it into a rated security and offloaded it to global investors, has collapsed. No one involved in the process had enough at stake if the loan went bad, so many bad loans were made. This applied more or less to all types of securitization, from residential and commercial mortgages to auto and student loans.

This doesn’t mean that securitization should be abandoned. The fundamental logic underlying the process is sound; it parses up the risks in lending and matches these risks with the risk tolerance of investors. More investors can thus participate, allowing more credit to flow to consumers and businesses throughout the global economy. Securitization should be fixed, and it can be.

The Fed’s TALF program is a crack at resurrecting the process of securitization. Investors get cheap loans from the Fed to buy various kinds of securities, and their downside—the amount they can lose if the securitization goes bad—is capped. The lenders participating in the program—the auto lenders and credit card companies, for example—hold on to the riskier parts of the securitization. If they make too many bad loans, they will suffer. That’s a good reason to make good loans. Whether securitization lives on after the TALF ends is debatable unless other more fundamental changes in the process occur.

One idea with some traction is the covered bond. It is a securitization, but the loans backing the security remain on the lender’s balance sheet. If loans go bad, the lender is responsible for replacing them with well-performing loans. If a lot of loans backing the security went delinquent and investors in the security stopped getting all their money, they would have the ability to go after the lender’s other assets. Lenders would have a very strong incentive to make sure that the loans are properly underwritten. For the covered bond idea to really get going, it might need both regulatory and taxpayer help.

It would be a mistake to scrap securitization altogether and go back to the simple originate-to-hold model that banks followed in times past. Credit would be much less ample and more costly, even for very creditworthy borrowers. Moreover, no guarantee ensures that this will forestall future financial missteps. Remember that the savings and loan crisis of the early 1990s was caused by the most plain-vanilla of lending institutions.

Policy Step #8: Overhaul Financial Regulation

The regulatory framework overseeing the nation’s financial system needs a top-to-bottom overhaul. The current byzantine regulatory structure contributed to the subprime financial shock, allowing the most aggressive lenders to avoid regulatory scrutiny. Regulators were also hamstrung in efforts to impose greater discipline on the industry, given the difficulties coordinating among themselves.

Regulatory oversight tends to be pro-cyclical. That is, when credit quality is good and lenders are aggressive, regulators have difficulty imposing discipline; when quality is poor and lenders are tightening, the disciplinary screws are tightened. This tends to exacerbate shifts in lending standards and credit availability. Partly it stems from regulators’ inability to respond quickly, but it also reflects the influence of politics on regulation. Lenders find it much easier to keep regulators at bay when credit conditions appear robust, although this is generally when increased regulatory oversight would be most beneficial.

The current fractured regulatory structure overseeing the financial system should be reworked into three principal agencies. The basic concept of regulation would shift: Instead of agencies monitoring specific types of financial institutions, regulators would specialize in various types of risks and activities. The Federal Reserve would look out for the stability of the entire financial system; its mandate would include any risk that threatened the system, whether it involved banks or hedge funds. The Fed is uniquely suited for this task, given its central position in the global financial system, its significant financial and intellectual resources, and its history of political independence. A second regulatory agency would oversee any financial institution that received an explicit government guarantee. Lenders couldn’t choose their regulator, as they do now, and would have consistent standards to work with. The biggest financial institutions, those that are “too big to fail,” would receive more stringent scrutiny; if they will get taxpayer help when things don’t go well, the quid pro quo is more oversight in the good times. The third regulatory agency would aim to protect consumers by monitoring how all financial institutions market their products. Certain government agencies watch over food, drugs, and the safety of consumer products; financial services need a similar type of watchdog.

Financial institutions and their products no longer fit in narrowly defined boxes. The risks they take cut across markets and extend around the globe. The regulatory structure needs to adapt, or it will be as irrelevant in the next financial crisis as it was in the subprime financial shock.

Policy Step #9: Pay Attention to Asset Bubbles

Conventional wisdom has long held that the Federal Reserve should not worry about asset bubbles and should set monetary policy without regard to the price of investments such as stocks or real estate. Those who hold this view doubt that it’s possible to identify investment bubbles anyway. Thus, they believe the Fed should stick to worrying about inflation and the real economy; if a bubble does burst, the central bank’s role is to clean up afterward and limit the economic damage.

Recently, this prescription has not worked particularly well. In the wake of both the late-1990s tech-stock bubble and this decade’s housing bubble, the Fed was forced to slash interest rates, with doubtful consequences for both financial markets and the real economy. The Fed’s ultra-low rates after the stock bubble burst helped inflate the subsequent housing bubble, and the low rates in the wake of the housing collapse could contribute to a developing bubble in energy and other commodity markets. Ignoring bubbles could abet their creation.

Cleaning up the economic mess from bursting bubbles has also proved difficult for the Fed. The financial system is the key conduit between monetary policy and the economy, and it is invariably a casualty of plunging markets. Lower rates can’t help a struggling economy if they don’t quickly translate into more and cheaper credit for businesses and households.

In fact, it might be possible to accurately identify bubbles. Not only are these characterized by rapidly rising prices, but they also involve increased leverage, surging trading volumes, and the arrival of less sophisticated buyers to a market in which they have little experience. Bubbles are always born out of something fundamental—for example, the Internet’s debut for stocks, low interest rates for housing, or Chinese demand for oil—making it difficult to conclude in real time that they are actual bubbles. Yet policymakers are often asked to make judgments of equal, if not greater, difficulty. Will record oil prices undermine inflation expectations and result in higher underlying core inflation? Is a zero funds rate target and the purchase of Treasury bonds an appropriate response to the subprime shock? Was putting the Fed’s balance sheet on the line to resolve the Bear Stearns collapse and save Citigroup and AIG beyond the Fed’s mandate? Asking whether there is a bubble in the housing market is not a more difficult question than these.

Yet policymakers might argue credibly that higher interest rates are too blunt an instrument to wield against bubbles. And so we are back to a regulatory response. Bubbles need lots of leverage, and regulators have many ways to affect the amount of leverage being used. A Federal Reserve that determines the nation’s monetary policy and is also its chief financial regulator could reduce the odds of future financial crises through deft use of its regulatory powers. However, this requires the central bank to also demonstrate the courage of its convictions.

Policy Step #10: Adopt a Bold Long-Term Budget for the Federal Government

Addressing the nation’s long-term fiscal problems is the most important and most intractable policy step on the top-ten list. Federal government debt is piling up quickly. The deficit will be close to $2 trillion in 2009 and about the same in 2010. This massive borrowing is necessary to quell the financial and economic crisis, but it will leave the government with a crushing debt load. Total federal government debt will increase from about 40% of the gross domestic product (GDP) before the crisis to as much as 70% in its wake. And unless big changes are soon made to the tax code and in government spending, the nation’s debt-to-GDP ratio will continue to rise rapidly as the aging baby boomers put increasing demands on Social Security, Medicare, and Medicaid. The math is unambiguous and daunting. Without big policy changes, global investors will demand increasingly higher interest rates to buy our debt and, at some point, will stop buying it altogether. The resulting financial and economic crisis will be worse than the current one.

Reducing our long-term budget deficits will require healthcare reform that successfully reduces the growth in healthcare costs, cuts in Social Security and medical benefits, and higher taxes. Although President Obama’s first budget is ambitious in many respects, it doesn’t go nearly far enough. The plan does raise taxes on higher-income households, but the additional revenues go to lower-income households and aren’t used to reduce future deficits. The plan does hold out the possibility of substantive healthcare reform, but instead of reining in medical benefits, it expands them. The plan is silent on Social Security.

Of course, it is too early to harshly judge the new President’s ability to address our long-term budget problems. He could well have the political fortitude and skill necessary to tackle them. However, he doesn’t have much time to convince global investors that he has what it takes. They have given us a pass on all the borrowing we will be doing in the next couple years. They understand this is necessary to end the crisis and reestablish economic growth—besides, a Treasury bond remains the world’s safest investment, at least for now. But investors fully expect that once the economy finds its footing, the borrowing will quickly become more judicious. The President needs to come up with more than an ambitious budget—he needs a bold one.

Personal Challenge

Policymakers won’t enact all the reforms on my top-ten list soon. Nevertheless, some substantive policy changes are coming. The financial and economic damage emanating from the subprime financial shock is a powerful catalyst for change. The mortgage-lending industry will face new rules, and Wall Street will live with new standards and oversight. Work will also begin in earnest on making the regulatory framework more effective in a globalized financial system.

Financial institutions and markets have also begun the task of repairing themselves. Wall Street is reengineering the subprime loan (soon to have a new name) and is refashioning the process of securitization. Banks are feverishly writing off bad loans and repairing their tattered balance sheets. Funds are raising billions from institutions and wealthy individuals to prepare to buy up distressed properties and securities.

Policymakers’ efforts, along with investors’ renewed enthusiasm, will eventually prevail; financial markets will settle and the worst economic downturn since the Great Depression will end. Although the next financial crisis is not in sight, there is no question that another one will arrive eventually. If the subprime financial shock has one lesson to teach, it is that that, no matter how sophisticated financial institutions, markets, and products become, those animal spirits—aka hubris—cannot be kept down long. Future generations will again come to believe that this time things are different, but they will ultimately overstep.

The most daunting challenge is thus a personal challenge. We must each prepare for the next financial crisis by carefully considering the condition of our own balance sheets. No longer can we count on rapid gains in stock and house prices. Lenders will be less forthcoming with credit, particularly to those who already have taken on their share. Social Security and Medicare benefits will almost certainly be cut for most of us. We will all have to save more and invest more carefully. Instead of piling into the next new thing, we should be diversifying away from whatever is appreciating quickly. These are simple principles that have long been the basis for sound personal finance and high finance—principles that many of us seemed to forget in the frenzy that produced the subprime financial shock.