Fault Lines: How Hidden Fractures Still Threaten the World Economy

by Raghuram G. Rajan

  Rising Asset Prices

  Rapidly rising asset prices should have sounded alarm bells. They were driven by a number of forces other than the traditional ones: increased risk taking, more foreign money looking for debt claims, and expanding credit.

  Low short-term interest rates pushed investors to take more risk, for a number of reasons.8 Some institutions, like insurance companies and pension funds, had contracted long-term liabilities. At the low interest rates available for safe assets, they had no hope of meeting those liabilities. Rather than falling short for sure, they preferred to move into longer-term riskier bonds, such as mortgage-backed securities, that paid higher interest rates. In addition, as long-term interest rates fell and the value of stocks, bonds, and housing rose, households felt wealthier and may have felt the confidence to take more risks. Some of these choices may have been irrational. As my colleague Richard Thaler has argued, when gamblers win money, they take more risks, because they treat their earlier winnings as “house” money—not their own—and therefore less important if lost. Whatever the reason, with investors more willing to take risks, the risk premium on all manner of assets came down.

  One effect of the search for yield was that money moved out of the United States into other countries, especially into the high-yielding bonds, stocks, and government securities in developing countries. But many of these countries were fearful of losing out in the race to supply goods to the U.S. market. Their central banks intervened to hold down the value of their currency by buying the U.S. dollars that were flowing into their countries from the domestic private entities that had acquired them and reinvesting these dollars in short-term U.S. government bonds and agency bonds.9 Thus, even as the Fed pushed dollars out, central banks in developing countries pushed them back in. In a number of industrial countries, private entities recycled the dollar inflows: German banks and Japanese insurance companies bought seemingly safe U.S. mortgage-backed securities with the dollars their customers deposited. The money leaving the United States looking for riskier assets around the world thus came back to the United States, looking for seemingly safe but higher-yielding debt-like securities. In some ways, Federal Reserve policy was turning the United States into a gigantic hedge fund, investing in risky assets around the world and financed by debt issued to the world.10

  Credit also expanded. Rising asset prices themselves gave households and firms the collateral with which to borrow—a channel that Chairman Bernanke himself had pointed out when he was a professor at Princeton University.11 Indeed, much of the financing of low-income borrowers was predicated on house prices rising and borrowers refinancing once the low teaser rates ran out. Thus a higher house price, rather than increased income, was the means through which borrowers would keep themselves current on payments.

  In addition, the promise that liquidity would be plentiful over the foreseeable future meant that bankers were willing to make longer-term illiquid, and hence risky, loans.12 But with firms unwilling to invest, banks went looking for deals that would create demand for loans.13 One option was for private equity investors to acquire firms, relying on banks to finance the deals. Banks, in turn, packaged the loans they made—creating collateralized loan obligations (CLOs)—and sold debt securities against them, thus obtaining the funds to make yet more loans. The result was that larger and larger leveraged acquisitions were proposed to satisfy the seemingly insatiable investor hunger for debt claims. As the rush to lend increased, lending standards declined rapidly: the classic signs of the frenzy were “covenant-lite” loans, bereft of the traditional covenants banks put in to trigger repayment if the borrower’s condition deteriorated, and pay-in-kind bonds, schemes by which borrowers who could not pay interest simply issued more bonds. As I argued earlier, the recent crisis was not caused only by lending to the poor!

  The Departure of Asset Prices from Fundamentals

  Rising asset prices would not be a problem if markets were well behaved and kept asset prices tied to fundamentals. In the case of housing, prices should be a function of interest rates, local demographics, household incomes, and local zoning regulations constraining the supply of housing.

  Unfortunately, asset price growth can be self-reinforcing. For instance, higher house prices give existing homeowners home equity that they can borrow against to make the down payment for better houses, leading to a rise in prices for those houses as well. And a history of house price growth can lead naive new home buyers to swallow their real estate agent’s sales pitch and put their money down expecting the price appreciation to continue. Indeed, for a while such expectations may be logical, because there are many more existing homeowners with enough home equity to move up.

  In most markets, savvy investors can take a contrarian position when prices depart too much from fundamental value. In the housing market (as well as in the market to take firms private), few opportunities exist for investors to take a short position—that is, sell houses they do not have so as to make a killing when prices fall. This typically means that the optimistic, who buy housing, tend to have undue influence.14 So house prices, and more generally, asset prices, can rise excessively, and their reacquaintance with reality can be brutal indeed.

  Central bankers argue that they really should not be in the business of figuring out when asset prices are too high: after all, do they really know that much more than market participants? This not a silly argument. Many markets work well by themselves, and introducing the whims and fancies of the central bank governor into the way prices are determined could create more problems than it solves. But history warns that markets such as housing, which are driven by bank lending, are different: not only are they very thin (relatively few house sales determine the value of housing for the whole country), but they also do not allow for investors to take short positions. Prices in these markets can run away from fundamentals. And the adverse spirals associated with house-price busts can be very damaging indeed : as prices fall, lending vanishes, and people cannot repay their mortgages; thus foreclosures increase, and prices drop further.

  The key warning signal of unsustainable growth in asset prices is an accompanying growth in credit.15 Before the crash of 1929, the warning signal was the growth in margin loans against shares even as stock prices increased. Before the most recent recession, alarm bells should have sounded in every central bank meeting as a boom in real estate lending accompanied house price growth, and lending to private equity grew with ever-higher transaction prices. Indeed, credit growth has historically been one of the factors determining how central bankers set policy interest rates; but in recent years, academics have persuaded many of them that such behavior is archaic. To their credit (no pun intended), the European Central Bank and some developing-country central banks, like the Reserve Bank of India, have continued to pay attention to credit growth in determining their monetary policy.

  Rapid credit growth was deemed of importance in the past partly because it was thought to presage inflation and partly because it reflected a possible deterioration in the quality of credit. Academics argued that the links between credit growth and inflation were tenuous (here they were right) and that credit problems were a historic curiosity in industrial countries because of improvements in bank management and supervision (here they were obviously wrong).

  A second argument central bankers offer is that in the midst of a frenzy, when investors expect double-digit rates of price growth, raising rates by a fraction of a percent is ineffective.16 There are two difficulties with this argument. First, the key issue is expectations. If the central bank can convince investors that it is serious about fighting asset-price inflation—in the same way as it convinces them it will fight goods-price inflation—expectations about price growth can deflate fast, especially in the early stages of a bubble. Put differently, small changes in the central bank interest rate can affect expectations about price growth considerably. The fact that asset prices are growing at double-digit rates does not mean that policy rates have to be
raised commensurately. Second, bubbles develop based on a kind of “greater fool” theory—that even if an asset is already trading at an inflated price, someone will be willing to buy it at an even more inflated price. By signaling that it will tighten liquidity conditions, and thus constrain financing and trading, the central bank can signal to investors that there will be fewer fools out there with the capacity to buy, making it more difficult for the bubble to grow.

  Indeed, instead of discouraging the development of bubbles, the Fed encouraged it through an implicit commitment, which might have done far more damage than any other Fed action. This commitment, the so-called “Greenspan put,” essentially said that the Fed could not really tell when asset prices were building up into a bubble, and so instead the Fed would ignore asset prices but stand ready to pick up the pieces when the bubble burst. To understand why this commitment was made, we need to go back to 1996.

  The Greenspan Put

  In late 1996, the Fed chairman, Alan Greenspan, an astute and experienced (though somewhat ideological) economist, became concerned about the high level of the stock market. In a famously brave speech at the American Enterprise Institute, he wondered whether the central bank should also worry when the prices of real estate, equities, and other earning assets were rising rapidly. And in the opaque language that he had perfected, he came as close as a central banker can to saying he thought stocks were overvalued:

  But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? … We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability…. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy.17

  In his autobiography, Greenspan admits wondering whether the market would understand what he was getting at.18 It did—and ignored him! The stock market opened substantially lower the next day but regained its losses in a day. And it was right to ignore him, because the Fed did not follow up Greenspan’s concern with an increase in interest rates, even though he had hinted at such action in his speech. Greenspan never explained why he did not act: quite possibly his hand was stayed by the furious reaction he engendered when market participants realized he was trying to talk the market down.

  Instead, the Fed watched while stock prices continued rising in the dot-com boom, as companies without earnings or even revenues sold shares at astronomical prices based on the number of “eyeballs” they attracted to their websites. The Fed even cut rates following the Russian debt default in 1998 and the collapse of the hedge fund Long-Term Capital Management, and raised interest rates mildly starting only in 1999.

  When the stock market eventually crashed in 2000, the dramatic initial response by the Fed ensured that the recession was mild even if job growth was tepid. In a 2002 speech at Jackson Hole, Alan Greenspan now argued that although the Federal Reserve could not recognize or prevent an asset-price boom, it could “mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.”19 This speech seemed to be a post facto rationalization of why Greenspan had not acted more forcefully on his prescient 1996 intuition: he was now saying the Fed should not intervene when it thought asset prices were too high but that it could recognize a bust when it happened and would pick up the pieces.

  The logic was not only strangely asymmetrical—why is the bottom easier to recognize than the top?—but also positively dangerous. It fueled the flames of asset-price inflation by telling Wall Street and banks across the country that the Fed would not raise interest rates to curb asset prices, and that if matters went terribly wrong, it would step in to prop prices up. The commitment to put a floor under asset prices was dubbed the “Greenspan put.” It told traders and bankers that if they gambled, the Fed would not limit their gains, but if their bets turned sour, the Fed would limit the consequences. All they had to ensure was that they bet on the same thing, for if they bet alone, they would not pose a systemic threat.

  Equally important, the willingness to flood the market with liquidity in the event of a severe downturn sent a clear message to bankers: “Don’t bother storing cash or marketable assets for a rainy day; we will be there to help you.” Not only did the Fed reduce the profitability of taking precautions, but it implicitly encouraged bankers to borrow short-term while making long-term loans, confident the Fed would be there if funding dried up. Leverage built up throughout the system.

  For a long time, central banks justified not focusing on asset prices by arguing that if Alan Greenspan had acted on his intuition in 1996, he would have snuffed out a boom that, despite the slump in 2000, took the stock market and U.S. household wealth to unprecedented heights. On March 2, 2009, though, the S&P 500 closed at 700, below its level of 744.38 on the day in 1996 when Alan Greenspan made his fateful speech. Of course, to date it has regained substantial ground, but perhaps Greenspan could have averted thirteen years of lost returns if indeed he had backed his words with action on interest rates. Whether the political system would have allowed him to do so is, of course, another matter.

  Monetary Policy and Financial Stability

  The recent recession has started some rethinking on the objectives of monetary policy, though even as I write, the Fed is keeping interest rates at rock-bottom levels because unemployment is high, even while all manner of asset prices are rising. The saving grace today is that credit growth is still tepid, and it is unlikely that we will have another housing boom while memories of the last one are still fresh. But the financial sector is, if anything, innovative, even in the ways it gets into trouble!

  I said earlier that academics and central bankers had converged on the view that there is no incompatibility between the objectives of seeking maximum growth and keeping inflation low in the long run. But there does seem to be some incompatibility between the monetary policies that encourage real investment and growth—maintaining predictably low interest rates over a sustained period and expressing a willingness to flood the market with liquidity when it is tight—and the monetary policies that discourage the coordinated one-way bets by financial market participants that have proved so damaging—pursuing unpredictable policies with no assurance of liquidity support.

  The argument that monetary policy has no role in leaning against asset-price bubbles is both timid and self-serving, and it takes the Fed out of a key role it can play in assuring financial stability. Of course the Fed should proceed cautiously and lean against an incipient bubble only when there is substantial evidence that it exists, tempered by the knowledge the fears of a bubble could be baseless. To resign the role of party pooper, however, is to buy political acceptability at great risk to the economy.

  More controversial is whether the Fed should cut policy interest rates to rock bottom in order to revive the economy. Although such an action seems costless, it imposes an enormous cost on savers and offers an enormous windfall to debtors, especially banks. Because it is a relatively hidden transfer, it elicits little comment or protest, especially as well-off savers tend to keep their heads down at times of crisis. But it is a transfer nevertheless, amounting to hundreds of billions of dollars a year. Moreover, it offers a one-way bet to bankers: plunge the system into trouble, and they will get a great deal on interest rates. Finally, it is not clear that ultralow nominal interest rates (around 0 percent) offer a significantly greater incentive for firms to invest than merely low interest rates (2 to 3 percent), but the difference in risk taking between ultralow and low interest rates could be enormous.

  More damaging still is the Fed’s ongoing attempt to prop up housing prices, both indirectly through low interest rates and directly by lending into the housing market. Althou
gh such support is justified as a way to allow the bubble to deflate slowly, it contributes to prolonged delays in adjustment in the housing market. Instead of homeowners and lenders biting the bullet on losses and moving on, they have the incentive to wait and see. But so long as there is a prospect for further adjustment, buyers, too, stay out of the market. And unless the oversupply in the housing market is cleared out, builders have little incentive to resume construction. The Fed could be not only delaying the recovery of the housing market but also reinforcing the sense that it will not get in the way of price increases but will prevent price falls. The Greenspan put is quickly becoming the Bernanke put.

  In sum, the Fed’s conduct of monetary policy between 2002 and 2005, while roundly criticized by all but central bankers and monetary economists (with notable exceptions), had two important limitations. First, it was fixated on the high and persistent unemployment rate and did its best to bring it down by trying to encourage investment. It signaled that it would keep rates low for a sustained period and offered the Greenspan put if firms were still not convinced. Critics should recognize that this fixation was in full accord with its mandate and, more important, that there would have been political hell to pay if it had raised interest rates much earlier than it did. This policy, however, may have had a greater effect on credit growth and asset prices than on job creation outside the real estate industry: corporations were still working away the excesses of the dot-com boom.