President Barack Obama, who took office amid an epic financial collapse, wants to make sure the economic recovery he’s helped engineer doesn’t set the stage for the next bubble. While the president has frequently talked about the need to move beyond what former White House economic adviser Jared Bernstein called a “shampoo economy” (as in lather, rinse, repeat), the topic of overheated markets has moved front and center once again. Obama this month spoke four times in five days of the need to avoid what he called “artificial bubbles,” even though the economy grew at just a 1.7 percent rate in the second quarter and employment and factory usage remain below pre-recession highs. “We have to turn the page on the bubble-and-bust mentality that created this mess,” he said in his Aug. 10 weekly radio address.
Six years after the housing meltdown ignited the worst recession since the 1930s and vaporized $16 trillion in American household wealth, real estate and equity markets are roaring again. Home prices are surging in places such as Las Vegas and Phoenix. U.S. stocks are near record highs, with the Standard & Poor’s 500-stock index up about 16 percent this year. In the past year investors’ use of borrowed money to buy stocks is up about one-third, to a near record. American companies have issued about $240 billion in junk bonds this year, more than twice the amount during the same period in 2007. “Clearly, this is a growing concern both in the administration and at the Fed,” says Adam Posen, a former member of the Bank of England’s monetary policy committee.
Republicans including Kentucky Senator Rand Paul and Texas Governor Rick Perry, and firms such as Pacific Investment Management, manager of the world’s largest bond fund, have criticized the Federal Reserve for fueling potential bubbles with cheap credit and through its asset-buying program known as quantitative easing. Obama, who has praised Fed Chairman Ben Bernanke for doing “an outstanding job,” sees bubbles arising from other causes. Chief among them: an increasingly skewed distribution of income. “When wealth concentrates at the very top, it can inflate unstable bubbles that threaten the economy,” the president said in a July 24 speech.
The 2010 Dodd-Frank financial sector overhaul created a Financial Stability Oversight Council, which is supposed to act as an early warning system for financial system risks. Despite the existence of this new watchdog, the administration and its appointees have turned up the volume in recent months on the need to stay alert to any imbalances that may be building. “Asset bubbles are a feature of our financial landscape,” said Sarah Bloom Raskin, a Fed governor nominated by Obama to be deputy Treasury secretary, at a Washington luncheon in July. “What happened before could happen again.” Bernanke told a Senate committee on July 18 that Fed officials are watching for signs of deteriorating credit standards, such as weaker loan covenants, that could signal destabilizing financial imbalances.
Some investors are also troubled by market frothiness. “We see artificial pricing in virtually every asset class,” says Mohamed El-Erian, Pimco’s chief executive officer. Others are more sanguine. “It’s a legitimate concern from an economic perspective,” says Roberto Perli, a partner in Cornerstone Macro, a Washington economic research firm, and a former Fed official. “But I don’t think it’s motivated by consideration of imminent risk.”
Posen, who currently serves as president of the Peterson Institute for International Economics, says he’s concerned that premature bubble worries may play too big a role in what may be the president’s most important economic decision of his second term: picking Bernanke’s successor. Obama may be inclined to select a replacement who’d be less likely to aggressively use monetary policy tools, says Posen, which could compromise the economic recovery. Even while the U.S. has rebounded more strongly than Europe, growth in the past four quarters has remained below the historical trend, as measured by the Chicago Federal Reserve Bank’s National Activity Index, a blend of 85 indicators. Says Posen: “There is a real danger if the president gets caught up chasing this ghost.”