SeriousBull

Fed Chief Studies Bubbles to decide Policy.

Tags: Bernanke + Bubbles + Credit crisis + Federal Reserve + investing

Fed Chairman Bernanke recruited a team of economist to study how and why asset “Bubbles” occur with the objective of setting, and improving, future Federal Reserve Policy.  The conclusion of this Princeton group

was that the Fed could and should prevent them. Jose Sheinkman added that “Advanced economies are very dependent on the health of the financial system. What this (Housing) bubble did was destroy the capacity of the financial system in the US economy.” His conclusion, in concert with his colleagues was that the Fed should and could restrain bubbles and the borrowing that fuels them.

Presumably this will mean that the Fed will work on benchmarking credit creation at some level for stable growth in the economy.  To do this they would surely study historical levels of commercial and consumer debt in the context of GDP expansionary & contractionary periods and set monetary policy to keep credit within a defined band range. Too much demand would be reason to raise rates to shunt credit demand and too little borrowing would necessitate lowering rates to create demand.

The problem with this approach is that it is a model methodology void of judgement and intuition that once again exposes the financial system to failure of oversight outside the financial model’s assumptions.  Moreover it would be a workaround to continue the considerable use of government guaranteed money by commercial banks to compete with investment banks instead of with private risk capital.

Indeed, instead of studying how asset bubbles come about, the issue is how credit bubbles come about. The Fed has demonstrated little expertise or savant judgement in curtailing speculation ahead of crisis by raising reserve capital or margin requirements. Instead of studying bubbles the Fed would be better served studying their own failures with the objective of improving on, and curtailing speculation when it should be obvious that sound credit lending principles are being wholly violated. In other words they needs to study how the Federal Reserve System can integrate more safeguards against irrational lending practices. Doing so would bring them to the “a ha” insight and conclusion that their is little irrational behavior in lending creating bubbles for they are all tied to profit incentive and often the government and the Fed Reserve policies are  responsible for the bringing about the financial problems since they sanction the means to multiply profits (and losses) with risk being passed on to third-parties.

Three of the most obvious recent examples are: (1) the Fed’s support of dismantling Glass-Steagall, (2) the Fed’s support of government mortgage-backed loans, and (3) the Fed’s support of widespread derivative contracts without regulation as a way to off-load risk.

Glass Steagall was a post Depression safeguard to assure adherence to sound lending practices by separating risk with public money from risk taking with private money–commercial banking separated from investment banking. With its revocation, advocated by former Fed Chief Greenspan, we paved the way for the current Housing bubble and credit crisis.  Likewise Federal programs that position banks as originators of loans with the government taking 90% of the risk by guaranteeing  loans that ordinarily would not be made create incentives to abuse the system. When the final tally is known, we will see that Ginnie Mae was the duped recipient of a banking manufacturing system gone awry for housing loans where profits were guaranteed without commensurate risk being assumed by the originator banks. Public tax dollars will pay for the losses. And lastly, derivative contracts, essentially bets on future financial outcomes can shift risk to third-parties. But at the extreme, as a study would clearly expose, they are a catalyst for fraud and abuse to unknowing investors including pension plans, individuals, mutual funds, and sovereign governments. Permitting unregulated use of derivatives without restriction with regard to recourse risk-management made it possible for banks and brokers to originate some ridiculous multiple of the entire global financial systems’ net worth.  And since, by definition in many cases, 50% of these may result in a loss, it exposes the world to financial collapse at worse or potential for debilitating shocks at least.

So let’s dismiss with the studies of how bubbles occur and be careful not to use the research as justification to obfuscate inadequacies and foster power grab politics.  Perhaps this time we got lucky and will escape the financial abyss, but not addressing real inadequacies will not suffice to escape eventual financial meltdown that will surely come one-day if intelligent safeguards are put in place now. That means, looking in the mirror and asking the right questions. In SB’s view that means asking how do innovative bankers deceive the present systems and how can we (the Federal Reserve and FINRA) recognise it and prevent it?

May 19, 2008 - Economy, Markets, Politics