Friday, January 22, 2010

The True Bank Bailout is Ongoing

I had a light bulb go off over my head the other day. Well, maybe it was less of an “aha” realization than an “oh yeah” recognition of the relevant facts. When we think about the bank bailouts that have occurred over the last two years we think of a number of measures. First, there were the direct interventions like the one the Fed engaged in by facilitating JP Morgan’s purchase of Bear Stearns. Another one that is still under the radar to most non-professional investors was the bailout of Fannie and Freddie. While the preferred share of those companies that had found their way onto banks’ balance sheets did get hurt by the fact that F&F were forced into conservatorship, the fact that the agency paper was not made worthless prevented the banks from suffering further losses. Then of course we have TARP, a bank slush fund created after Hank Paulson put a gun to the head of Congress. As Elizabeth Warren continues to attest, we have no idea what happened within these banks to the money they received. I understand that money is fungible (making it irrelevant what the precise funds coming from TARP were used for) but the goal of the TARP-enabling legislation was not have banks use the extra funds to engage in risky activities or hoard the money by refusing to lend it out. Based on just about any data you look at, this is exactly what the TARP money was used for.

Then of course was the FDIC’s backing of bank debt, a subsidy that allowed banks to issue debt at fractions of what it would have cost without the FDIC guarantee. Furthermore, allowing Goldman and Morgan Stanley to become bank holdings companies basically overnight was a bailout that allowed them access to additional cheap funding from the Fed and FDIC. We also must not forget (how could we—this is the story that unfortunately never dies) the bailout of AIG’s counterparties on all of AIGFP’s terribly ill-conceived derivative bets. Each detail that emerges in this ongoing saga suggests that the banks were paid 100 cents on the dollar for assets that were worth quite a bit less, without any regard for the consequences for taxpayers.

Next, the how can we forget that the FASB grudgingly relaxed mark to market accounting rules, a decision that may more than anything else have allowed the banks to postpone the day of reckoning when it comes to the worst assets on their balance sheets. I don’t think it is a coincidence that along with the confidence built after the so-called successful stress tests that the banks stocks have rallied massively since then. This fortuitous reversal has allowed banks to raise additional equity at prices that were not unreasonably dilutive and the increase in stock prices has inexplicably calmed creditors’ nerves and led to narrower CDS spreads despite many risks not having been eliminated. Finally, it appears that all of the new Treasury issuance and Fed activity through primary dealers has provided a windfall of trading revenue for the big banks. I haven’t really dug into the data on the profitability of government desks but you know the banks are making basically risk free profits from all of the government’s interaction with the markets.

Wow. I had never really enumerated the number of different full scale and quasi-bailouts before. It really is unbelievable and from what have I read regarding US history, also unprecedented, at least in terms of scale. No doubt I have also forgotten some events and details but the message that the government sent to the banks was clear: not only are you too big to fail, but we are also going to do whatever we can to help you get back to profitability and stabilize your balance sheets. Unfortunately, the message of US taxpayers has been commensurately blunt: despite the fact that the banks had a hand in this crisis, their health is pivotal to US economic prosperity and it is your job(my dear taxpayer) to backstop them and suffer the associated economic hardship as we nurse the banks back to health. It was within this context that I realized which bailout/subsidy was the most unappreciated and maybe even most harmful to people on Main Street.

What I am referring to is the zero interest rate policy (ZIRP) of the Fed. While the taxpayer losses that will eventually come out of TARP, FDIC debt guarantees, and the explicit extend and pretend policy are tough to quantify, the impact of miniscule rates on US savers is pretty easy to determine. According to this data from ICI, at the end of December 2009 there was close to $3.3 trillion in US money market funds. I don’t even have to include checking and savings accounts that are paying virtually no interest to illustrate the impact of low rates on savers. Specifically, according to, the current average high yield money market rate is 1.03%. So, if there were no outflows and the rate remained the same for the rest of the year (clearly this will not be the case but I want to illustrate a point here), that $3.3 trillion would earn total interest for a full year of about $33 billion or $110 for every one of the 300 million people in the US.

Unfortunately I had some trouble finding data on historical money market rates. But, on the Fed’s website there is data going back to 1964 on the average 6 month CD rates. Right now the average rate on standard six month CDs is about 1.03%, almost exactly what the money market rate is offering. Let’s just assume that rates on these short duration CDs are a reasonable proxy for money market rates. The 1964-2009 average is about 6.42%. If you exclude the high interest rate environment that was pervasive in the mid-1970’s and 1980s, the average rate from 1990 to 2009 was about 4.37%. So it is not hard to see the impact of the Fed’s low interest rate policy has had on people who depend on interest on their cash. Using the 1964-2009 average rate implies $211.89 billion or $706 of interest per year per person. Even the 1990-2009 average rate yields $480.70 of interest per year per person. I would say that when you have so many people struggling to meet end meat these differences are not trivial. In fact, I would even go as far to say that this is a form of stealing from the poor to give to the rich. Not exactly the kind of behavior that leads to a stable society.

I can already hear the Fed apologists and proponents of low interest rates as a cure for all our ills saying that higher interest rates would surely destroy an economic recovery and thus ZIRP is justified. This may be true to some degree. I do understand the need keep interest rates low to encourage borrowing in hopes that people will start to invest again and the economy will rebound. Unfortunately, the Fed’s position that interest rates should stay low for an extended period of time in order to help revive the economy is kind of like an arsonist leaving the fire hose on indefinitely after he puts out the fire he created. Yes, maybe it is necessary but what further damage is being done? My answer to that is the savers are being punished by the low interest rate environment while the banks use low short term rates, just about interest free funds from the Fed and a steep yield curve to literally print money. Yes, this helps banks earn their way through the cycle. Yes, we do want a functioning banking system in the US. But none of that takes away from the fact that in order to achieve those goals people on Main Street have taken another hit to their incomes. After the banks help precipitate a global financial crisis that caused many asset classes to plunge in value and severely damaged the retirement plans of millions of people, somehow that just doesn’t seem fair, does it?

I would be remiss not to mention that low interest rates cause people who are searching for yield to go further out onto the risk curve whether they can afford to or not. While there is little data out there that suggests that Main Street has jumped back into stocks, there is no question in my mind that banks, traders, and hedge funds have once again embraced risk. The problem is that the structural problems and risks inherent in our financial system have not disappeared. If anything, the risks are even more concentrated than before and with Congress locked in irrelevance we are unlikely to see meaningful reforms anytime soon that would address this problem. So when you have fewer players making bigger and more flammable bets with cheap money provided by the Fed, it creates a dangerous cocktail. What happens if it all blows up again? Well, even if Washington decided not to bail out the culprits (highly unlikely as that is) the impact on asset markets would surely only harm savers and retail investors even more.

So, as we employ all these means in an attempt to determine what went wrong and how to stop it from happening again, we can’t forget that not everything is solely visible through the rear view mirror. In fact, we can see the pain caused by ZIRP as we look out through the front windshield. Let’s just hope the people in charge of reforms and future policies remember that it is Main Street that loses the most when the Fed and the banks create huge booms and busts. For the US to create a sustainably prosperous economy and high quality of life society, I have no doubt this dynamic must change. And soon; before we have hit the point of no return.

(Picture courtesy of

Monday, January 18, 2010

Help Haiti & Recieve A Valuable Membership for Free

Dear Readers,

My friend at contacted me about a promotion he is running in an attempt to raise money for the people affected by the recent earthquake in Haiti. Here is the information he provided me regarding the generous offer:

"In solidarity with those affected by the earthquake in Haiti, will be providing a free premium membership, including a subscription to our monthly ValueFocus Newsletter, to readers who donate more than $30 to the ValueHuntr Haiti Relief Fund below. This offer expires Friday, January 22nd.

It is our hope that this will provide an extra incentive for our readers to donate. We guarantee you that all funds collected will be donated to the Haiti Relief and Development Fund of the Red Cross (we will send receipt to donors as proof)."

The link is:

I ask people to contribute whatever they can and urge them to take advantage of the opportunity to receive a great newsletter as well. I understand that a lot of people are currently struggling in their own right. I'm not sure the dislocation between the boom on Wall Street and the near depression on Main Street has ever been more dramatic. But we have to remember that most of us have won what Warren Buffett calls the Ovarian Lottery. Those of us who were born in developed countries with ubiquitous infrastructure and endless opportunities for future prosperity are incredibly lucky. No matter how stellar our intellect or amazing our talents, if we had been born in different circumstances our chances of achieving professional and personal success would have been much more limited. Accordingly, it is our obligation to help those who are suffering and it is clear from the disturbing images currently being shown on the news that the Haitian people are suffering beyond what just about any Americans can fathom.

So, times are tough. The US deficit continues to increase by the millisecond. Underemployment continues to levitate at distressing levels. We somehow are still fighting two wars. But none of that should feed a tendency to lean towards ethnocentrism. One of the lessons of the Great Depression was that protectionism and turning inward only prolonged the slump. So let's take this opportunity to show our solidarity with the rest of the world and do whatever we can to help the people of Haiti.


The Inoculated Investor

Friday, January 8, 2010

The Best Links of the Week That Was

Looks like the government piling up all that debt is a problem after all: Who would have thought that endlessly accumulating debt to finance current spending obligations could be a bad thing? Come to think of it, the reminders of the risks associated with excessive leverage are probably the central lessons that have emerged from the credit crisis. Even households are starting to understand that you can’t borrow and spend your way to sustainable prosperity and subsequently have been tightening their purse strings. Unfortunately, this intuition has clearly been lost on the US government. Specifically, the backdrop of the need to stimulate a depressed economy has given the powers that be in the US a remarkably convenient excuse to ignore these lessons and continue to borrow with reckless abandon. Aside from the usual risks like default, debt service as a percentage of total revenue increasing as rates rise and the destruction of the US dollar, authors Carmen Reinhart and Ken Rogoff now find that future growth may also be impacted by unsustainable debt levels:

In a new paper presented Monday at the annual meeting of the American Economic Association, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard study the link between different levels of debt and countries’ economic growth over the last two centuries. One finding: Countries with a gross public debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.

The results are particularly relevant at a time when debt levels in the U.S. and other countries at the center of the financial crisis are rapidly approaching the 90% threshold. Gross government debt in the U.S., for example, stood at 85% of GDP in 2009 and will reach 108% of GDP by 2014, according to IMF projections. The U.K.’s gross government debt stood at 69% of GDP in 2009 and is expected to reach 98% of GDP by 2013.

“If history is any guide,” the rising government debt “is very troubling for the U.S. and other advanced economies,” says Ms. Reinhart.

Left unaddressed, it appears that the US’s debt to GDP ratio will cross the 90% point of no return threshold in the next few years and that event could dampen an already meager growth rate. I don’t think I have to point out that a lot of the budget projections that have come out over the last year have included some particularly rosy estimates of future GDP growth. If the debt and deficit collaborate to stunt that growth then suddenly the US has to borrow more than anticipated even though tax revenues are unlikely to increase without meaningful GDP growth. I don’t know what the technical definition of a debt spiral is, but this situation sure sounds like one.

Would a bonus deferral scheme help solve the compensation problem on Wall Street? James Kwak of The Baseline Scenario recently created an interesting post on the potential way to remedy the misaligned incentives issue that is the plague of the taxpayer and a windfall for Wall Street traders. At just about every firm bonuses are paid on a yearly basis even though it could take years for the success of certain trades to be ascertained. Recent trading “profits” stemming from RMBS and CMBS assets come to mind as those that have looked great for a while but then turned into crippling losses when the housing and commercial real estate markets started to implode. A trader who loaded his company’s balance sheet with MBS probably looked like, and was compensated like, a star when the prices of these securities were going up. But then when some of these securities could not be unloaded without taking gigantic losses a few years later, most firms reluctance to claw back past bonuses meant this trader got to keep his bonus even though his trades endangered the going concern status of the institution. Recently, this dynamic has meant heads the trader wins and tails the taxpayer loses as the government has been forced to bail out the firm in question when its balance sheet caught fire.

There has to be another way right? Let’s review what Kwak’s idea is:

Instead, what about making your 2009 year-end bonus based on your performance in 2006, 2007, and 2008? That is, by the end of 2009 you would have better information about whether the trades placed in those years had turned out well or badly. There are all sorts of variations possible: you could weight the years differently; you could include 2009 (with a low weight because it’s too early to tell); you could do it on a quarterly basis to smooth out the lumps; you could pay out on a quarterly basis; and so on. But the basic principle is that you don’t calculate the bonus until enough time has elapsed to ensure that the employee deserves it. If you wait long enough, you could even just pay it out in cash instead of restricted stock.

The first objection will be that new employees get screwed, since they will get lower bonuses until they have been with the company for a few years. There are a couple possible solutions to that. The one I like less is that for someone who joins on 1/1/2009, his 2009 bonus could have a full-size target and be based on 2009 performance; but his 2010 bonus would be based on two years of results, his 2011 bonus on three years of results, and his 2012 and later bonuses on four years of results.

My preferred solution, though, is that people simply get smaller bonuses (and maybe somewhat higher salaries to compensate) when they switch companies, and only get the big bonuses after they’ve been around a few years. (You can imagine a new equilibrium where bonuses for employees in their first years are lower than today, but bonuses for long-term employees are higher. I’m not saying in this post that total compensation has to go down; that’s a separate issue.) In the technology startup industry, employees get stock options that vest over four years (with a one-year cliff). If you leave after two years, you give up your last two years of options (and unless the company is already public, you have a difficult choice about whether or not to exercise your options). This increases the cost to the employee of switching companies, which is good on two levels. First, as far as the division of the pie is concerned, it benefits employers (shareholders) relative to employees, which would be a good thing for the banking industry (as opposed to, say, the fast food industry). Second, it makes the pie bigger, since companies are more productive if they have more stable workforces. For these reasons, banks should actually want to move to this type of bonus calculation.

Although the exact calculations of yearly weights or how many years to include when determining a bonus need to be worked out, this seems like an infinitely better scenario (for taxpayers) than what we have now. Currently, traders have the incentive to make as much money now as possible with little regard for the future consequences. But, if a big bonus after a particularly profitable year were deferred, a trader’s time horizon would be elongated in a way that reduced the possibility of a future blow up. This would actually be great for the bank and would protect taxpayers a lot better without capping or reducing compensation. I’m sure if such a scheme were ever forced upon members of Wall Street I would be able hear their cries from Los Angeles. But, if the goal is to create a more stable financial system in which individual participants are reluctant to take excessive short-term risks because their own compensation is one the line, then maybe Obama and Congress should ignore those ubiquitous financial lobbyists on this topic.

You don’t always have to use a bazooka: In 2008 former Treasury Secretary Paulson likened the threat to take over Fannie and Freddie to having a bazooka that he hoped not to use. In the end, he eventually did have to use the bazooka but the sentiment of his comment was interesting. He thought that the threat of nationalization or conservatorship would be enough to force Fannie and Freddie to reform their money losing ways. In retrospect, by the time he made that threat it was way too late as it had become abundantly clear that F&F had filled their balance sheets with such toxic waste that the HAZMAT team needed to be summoned.

The truth is that in the past sometimes all government officials or the Fed had to do was hint at taking action in order to change market sentiment or practice. Unfortunately, the financial crisis has diminished the credibility of such threats. When Tim Geithner talks about the US’s commitment to a strong dollar people laugh at him and the markets ignore him. However, the Fed does this type of thing all the time and it appears to still be working. Without any actual action, all the Fed has to do is say that rates will be held low for an “extended” period and the market gets the signal that interest rate hikes are not forthcoming immediately. We will see how long this continues but for now the Fed has the ability to pull out the bazooka but not actually fire.

In his most recent piece, Martin Hutchinson of The Prudent Bear goes through a list of potential actions the government could take to incrementally help solve our myriad problems without actually pulling out the big guns. Think of it as pulling out a pistol as opposed to a rocket launcher. It is now painfully obvious that Congress cannot pass single bills that address all of the issues that need attention and if they do, the bills are 20,000 pages long and contain so much pork that they would make pig farmers blush. That’s why I think it makes sense to take little steps like the ones suggested by Hutchinson. Unfortunately, as he details below, the government could also use its pistols in ways that do not tackle the long term conundrums facing the US and only kick the can down the road at the expensive of future taxpayers:

The Christmas Eve decision by the U.S. Treasury to extend unlimited support to Fannie Mae and Freddie Mac was such a policy, albeit one pointed in a pernicious direction. In reality, it makes very little difference; Fannie and Freddie have such massive political support that no kind of devastation in their home mortgage operations would cause the Obama administration to abandon them. However, the unlimited support line from the Treasury allows them to extend their pernicious operations aggressively, thus diverting yet more U.S. capital into the wasteful housing sector, and increasing the contingent liability on taxpayers still further.

Come the November midterm elections, the Democrats will be able to claim that house prices have recovered substantially on their watch. However, a market that is propped up artificially in this way has a tendency to extract its revenge by requiring still larger and larger subsidies in order to avoid collapsing to its true equilibrium level, perhaps still 15% below current levels. Thus the cost to taxpayers, homeowners who buy houses in 2010 and the U.S. economy in general from this particular "miracle" of Treasury sleight of hand will be substantial.

Turning in the opposite direction, to an action of no direct economic consequence that could cause a genuinely useful miracle, we can consider the effect of a modest increase in the federal funds target rate, perhaps to a trading range of 0.25% to 0.50% from its current 0% to 0.25%.

This would have no immediate economic effect. With inflation already running at 2% to 3% and heading higher, short-term rates would remain heavily negative, so monetary policy would remain hugely "stimulative" as Ben Bernanke and the political class wants it.

However, such a move would have a considerable effect on commodity and energy markets. Currently, the main near-term threat to continuing economic recovery arises from these markets, in which prices are continuing to rise and may at some point get to levels that threaten recovery, by draining purchasing power out of commodity-using Western economies and/or produce a confidence-sapping acceleration of inflation…

The United States could have a similar benign effect by agreeing to raise the eligibility age for Social Security and Medicare entitlement by one month each year from 2026, the year in which the Social Security retirement age reaches 67. Such a change would have no direct economic effect at all for the next 16 years but it would at a stroke eliminate the long-term deficit in the Social Security system and greatly reduce that in the Medicare system.

Further reductions in the Medicare system's deficit certainly require a year or two to allow the whole health-care question to be depoliticized after 2009's battles. Then, some cost-saving measures such as limiting damage awards for medical malpractice are themselves highly political.

However, there is one counterintuitive measure that could be taken which would hugely reduce costs in the system overall even though at first sight it would increase federal funding for health care. That would be for the federal government to fund properly the mandate it imposed on hospitals in 1986 to treat indigent patients in emergency rooms, without regard to their ability to pay. If the federal government reimbursed the costs of this mandate, hospitals would no longer have to load the losses onto the charges for insurance-covered patients or the even higher charges on individuals, nor would they have to employ a large staff chasing deadbeats. Since the unfunded cost of emergency room treatment is estimated at $80 billion annually, transferring that burden to government would save two or three times that amount from the costs to insurance companies and individuals of medical treatment, probably saving 1% of GDP from health-care costs by that reform alone.

Does the US have more criminals on a per person basis than the rest of the world or just laws that are too restrictive? It is hard for me to believe that the average person in the US is more likely to engage in criminal activities than someone in a third world country. But that’s what the data regarding the number of incarcerated Americans relative to the US’s percentage of total world population would seem to imply. In reality, without doing a lot of research on the subject I surmise that the reason for this is that the US just has much more developed policing practices, court systems and jail infrastructure. If another country does not have to resources to catch, prosecute and then incarcerate its criminals then of course it would have fewer people in jail on a relative basis.

The problem now is that our ability to house the criminals that we are so good at catching is diminishing fast. The cost of holding all of these people in jail has begun to cripple state budgets. So, we really need to figure out what to do before states literally are forced to raise taxes on the rest of us just to keep so many people locked up. Either we need to change the laws that define what a criminal is or shorten the time that certain types of lawbreakers are forced to stay in jail. In retrospect it may have been a poor decision to put people in jail for having a minimal amount of pot or when their third strike was jaywalking, for example. Thus, we need to assess the actual threat that nonviolent offenders pose on broader society. I have no problem keeping murders, rapists, child molesters, and drug traffickers in prison. There is no question that isolating those people from the rest of us is necessary to maintain some sort of civilized and functioning society.

I just think it makes sense to try to rehabilitate some people outside of jail by helping them gain skills that allow them to re-enter the workforce. My guess is that in just about any scenario the cost of job training or classes about how to properly function within the mainstream society would be a fraction of what we now spend feeding and monitoring these individuals in jail. Not surprisingly, as this NY Times editorial points out, there is some data that supports at least trying some of these alternative measures:

The United States, which has less than 5 percent of the world’s population, has about one-quarter of its prisoners. But the relentless rise in the nation’s prison population has suddenly slowed as many states discover that it is simply too expensive to overincarcerate.

Between 1987 and 2007 the prison population nearly tripled, from 585,000 to almost 1.6 million. Much of that increase occurred in states — many with falling crime rates — that had adopted overly harsh punishment policies, such as the “three strikes and you’re out” rule and drug laws requiring that nonviolent drug offenders be locked away.

These policies have been hugely costly. According to the Pew Center on the States, state spending from general funds on corrections increased from $10.6 billion in 1987 to more than $44 billion in 2007, a 127 percent increase in inflation-adjusted dollars. In the same period, adjusted spending on higher education increased only 21 percent…

One factor seems to be tight budgets as states decide to release nonviolent offenders early. This can not only save money. If done correctly, it can also be very sound social policy. Many nonviolent offenders can be dealt with more effectively and more cheaply through treatment and jobs programs.

Michigan, which has been hard hit by the recession, has done a particularly good job of releasing people who do not need to be in prison. As the American Civil Liberties Union’s National Prison Project details in a new report, Michigan reduced its prison population by about 8 percent between March 2007 and November 2009 by taking smart steps, notably doing more to get nonviolent drug offenders out, while helping in their transition to a productive, and crime-free, life.

What we don’t know is whether crime also increased in Michigan after the prisoners were let go. A skeptic might argue, “once a criminal, always a criminal.” But it doesn’t appear that states have enough money to incarcerate all the people who they decided were criminals so at some point tough choices must be made. I don’t see the harm in implementing prison reduction programs on a trial basis in states that have the resources to monitor the released individuals and properly assess the ongoing risks they pose to society. You never know. We might be pleasantly surprised by the outcome.

(Picture courtesy of

Sunday, January 3, 2010

Is it Possible Bernanke has Seen the Light?

Marc Faber calls him a dangerous inflationist. Nassim Taleb likens him to an arsonist who now has the task of putting out the fire he started. Despite his mild mannered, soft spoken nature, could Ben Bernanke and his seemingly religious beliefs about financial markets be long term threats to the stability of the US? In general, I worry that his willingness to monetize the US debt has put us on a path to uncomfortable levels of inflation. But, from his comments this morning (as covered by the Associated Press and printed in the NY Times) to members of the American Economic Association, there may be some hope that the events of the past few years have taught him something about the dangers of misguided monetary policy.

First, when I read the headline in the Times I almost fell out of my chair. The article is titled "Bernanke Calls for Regulation to Fight Future Bubbles." Say what??!! You mean that the guy who basically said he did not believe in bubbles was actually advocating some kind of policy response to prevent bubbles? If true, this would be tantamount to Alan Greenspan's recent admission that the financial meltdown had proved to him that the entire framework from which he had viewed financial markets during his career was wrong. That statement is still shocking to me in terms of its magnitude. Kind of like a Minsky Moment, I would deem this a Greenspan Moment. For me, that would be like Warren Buffett, Ben Graham and Seth Klarman being exposed as Bernie Madoff-like frauds. If value investing turned out to be nothing more than an elaborate, multi-generational Ponzi scheme I'm not sure what I would do. I can assure you that getting out of bed the next morning would not be particularly easy.

Could Bernanke really have come to a commensurately game changing realization? I was skeptical but I had to find out. Fortunately, as investors we are blessed by the Fed’s never ending desire to be transparent and the speeches by the Fed governors are posted on its website. Bernanke’s speech starts off in a promising way (for those of us who want to Fed to understand the potential disastrous effects of its decisions):

“Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.”

Promising, but not particularly introspective. This paragraph seems to imply that the Fed sees itself as an evaluator of the failures of other agencies and the legislative body as opposed to a willing participant in all of the bubble era madness. This type of dissociation from the systemic problems that have emerged recently is clearly troubling and indicates an unwillingness to seriously examine what role the Fed played in creating the housing bubble and allowing financial institutions it was supposed to be regulating to become levered to the hilt.

“Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices.”

At least he understands the criticisms that have been thrown so vigorously at the Fed from a wide range of politicians, economists, bloggers and market professionals. Personally, I agree with Bernanke to some extent that interest rate policy may not be the best tool for popping or preventing asset bubbles. To me that would be like trying to tee off with a baseball bat; good luck trying to precisely drive the ball. Unfortunately for the Fed, this does not absolve the members of responsibility for allowing the housing bubble to inflate so dramatically as the Fed was one of the primary institutions in charge of curbing predatory lending and excessive balance sheet growth. Also, with the benefit of hindsight I think it is very hard to argue that the excessively low interest rates in the early part of the decade were appropriate given the macroeconomic circumstances. I am not an economist but it seems logical that historically low interest rates, especially those stemming from the zero interest rate policy in place now, should only be used in very dramatic circumstances.

Not to downplay the significance of the impact of the September 11th attacks or the bursting of the tech bubble but I am unsure that a response to those events that included leaving interest rates under 2% from December 2001 to December 2004 was justified. Bernanke exhausts a lot of energy attempting to defend the monetary policy of this period by citing low inflation and a jobless recovery as contributing factors as well as illustrating how the Taylor Rule that indicated that rates were too low was not the perfect metric. However, my focus is not to admonish the Fed leaders for past mistakes, especially since Bernanke did not become Chairman until 2005. My concern is simple: until the Fed is willing to recognize that there are severe risks to leaving interest rates at depressed levels for an extended period it is likely to continue to play a major part in what I see as a particularly negative perpetual boom and bust prone US economic model.

“To set the stage for the discussion, Slide 5 shows the annual increase in nominal house prices from 1978 to the present.11 After some years of slow growth, U.S. house prices began to rise more rapidly in the late 1990s. Prices grew at a 7 to 8 percent annual rate in 1998 and 1999, and in the 9 to 11 percent range from 2000 to 2003. Thus, the beginning of the run-up in housing prices predates the period of highly accommodative monetary policy. Shiller (2007) dates the beginning of the boom in 1998. On the other hand, the most rapid price gains were in 2004 and 2005, when the annual rate of house price appreciation was between 15 and 17 percent. Thus, the timing of the housing bubble does not rule out some contribution from monetary policy.”

Hmmm, in 2004 and 2005 housing prices were growing at more than twice the rate seen in 1998 and 1999 and at least one and a half times the rates seen in 2000-2003? Shouldn’t that have been a sign that the housing market was getting a bit frothy? Maybe, according to Bernanke, but in his mind the magnitude of increase had nothing to do with monetary policy. Instead he blames it on poor underwriting standards and exotic mortgage products:

“With respect to the magnitude of house-price increases: Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.12 This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory…”

“The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed. This description suggests that regulatory and supervisory policies, rather than monetary policies, would have been more effective means of addressing the run-up in house prices.”

Also, Bernanke argues that since housing prices were increasing across the globe during this period, if low rates were the culprit we would expect to see a similar impact across countries. According to Bernanke the data does not support a correlation between monetary policy and housing appreciation but does support a relationship between a global savings glut (and the associated capital inflows from emerging markets) and housing booms:

“As Slide 9 shows [click through to see all of Bernanke’s slides], the relationship between the stance of monetary policy and house price appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and greater house price appreciation than the United States. The overall relationship between house prices and monetary policy, shown by the solid line, has the expected slope (tighter policy is associated with somewhat slower house price appreciation). However, the relationship is statistically insignificant and economically weak; moreover, monetary policy differences explain only about 5 percent of the variability in house price appreciation across countries.

What does explain the variability in house price appreciation across countries? In previous remarks I have pointed out that capital inflows from emerging markets to industrial countries can help to explain asset price appreciation and low long-term real interest rates in the countries receiving the funds--the so-called global savings glut hypothesis (Bernanke, 2005, 2007)… The downward slope of the relationship is as expected--countries in which current accounts worsened and capital inflows rose (shown in the left half of the figure [see Slide 10]) had greater house price appreciation over this period.18 However, in contrast to the previous slide, the relationship is highly significant, both statistically and economically, and about 31 percent of the variability in house price appreciation across countries is explained.19

Based on all of this fancy statistical data, Bernanke draws the following conclusions:

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak. Because monetary policy works with a lag, policymakers' response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period--though certainly accommodative--does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives. House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases…

The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country's overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms…

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach. Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era. Maintaining flexibility and an open mind will be essential for successful policymaking as we feel our way forward.

And there folks, highlighted above, seems to me to be a bombshell. Just the hint that monetary policy could be used in the future to address the risks associated with asset bubbles appears to indicate a very positive evolution in the thinking of the Fed Chairman. Over the last year I have read the majority of his speeches and correct me if I am wrong, but I do not recall him ever been this forthcoming and open to adjusting Fed strategy when it comes to asset bubbles. Was this Bernanke’s Greenspan moment? Does this mean the Fed is going to be much more aggressive in raising interest rates this time around? Are those worried about rampant inflation or even hyperinflation going to be proven wrong as a result of a new Volcker-like philosophy coming from Bernanke? I am skeptical based on his historical bias towards inflation, his extreme fears of deflation, his desire to prevent another deflationary Depression, his staunch defense of past Fed looseness, and his beliefs about the impact of monetary policy on the housing bubble. But, those final words provide me with a modicum of hope that I sure did not have when I woke up this morning. Maybe 2010 is going to be a better year than I have been anticipating.