Obama Focuses on Risk of New Bubble Undermining Broad RecoveryDavid J. Lynch
President Barack Obama, who took office amid the collapse of the last financial bubble, wants to make sure his economic recovery doesn’t generate the next one.
Obama this month spoke four times in five days of the need to avoid what he called “artificial bubbles,” even in an economy that’s growing at just a 1.7 percent rate and where 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.
Obama’s cautionary notes call attention to the risk that the lessons of the financial crisis, which was spawned by a speculator-driven surge in asset values, will be forgotten, widening the income gap and undermining a broad-based recovery.
“Clearly, this is a growing concern both in the administration and at the Fed,” said Adam Posen, a former member of the Bank of England’s monetary policy committee.
While economists are more concerned with inadequate growth, there’s reason for vigilance. Thanks to low borrowing costs, U.S. companies have issued $241 billion in junk bonds this year, more than twice the amount during the same period in 2007; investors’ use of borrowed money to buy stocks is up about one-third in the past year to a near record, and housing prices are surging in areas such as Las Vegas and Phoenix.
U.S. stocks also are near record highs, with the Standard & Poor’s 500 Index rising about 16 percent so far this year.
That may explain why six years after the housing meltdown ignited the worst recession since the 1930s and vaporized $16 trillion in household wealth, bubble reminders are intruding on Obama’s speeches.
“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.”
The U.S. recovery, outpacing Europe and Japan, has created 6.7 million jobs since February 2010. Claims for jobless benefits fell last week to their lowest level in almost six years. And after a two-decade-long borrowing binge, households have pared their debt burden to mid-1980s levels.
Still, growth has been below historical trend for the past four quarters, according to the Chicago Federal Reserve Bank’s National Activity Index, a blend of 85 indicators measuring employment, production, housing and consumption.
Obama’s words of caution come as he decides who will replace Federal Reserve Chairman Ben S. Bernanke, probably the most consequential economic decision of his second term.
The president has said he is considering potential successors, including Lawrence Summers, a onetime Treasury secretary and White House adviser, and Janet Yellen, the current Fed vice chairman.
Perli says both candidates can claim bubble-battling expertise. Summers earned plaudits for managing the U.S. response to the 1997 Asian financial crisis as well as advising Obama in the aftermath of the housing bubble’s collapse. Yellen was among the first to see how bad the recent bust would be, warning Fed colleagues at a December 2007 meeting, “The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real.”
Republican opposition to increased government spending has left monetary policy to bear most of the burden of spurring the economy. The Federal Reserve has kept interest rates near zero for almost five years and expanded its balance sheet to more than $3.6 trillion, up from about $900 billion at the time of Lehman Brothers’ bankruptcy in September 2008.
Republicans and firms such as Pacific Investment Management Co., manager of the world’s largest bond fund, have criticized the Fed for fueling potential bubbles with easy credit and through its asset-buying program known as quantitative easing.
Obama doesn’t share that criticism, saying in June that Bernanke has done “an outstanding job.” The president 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.
When the wealthy lend ever-greater amounts to less-affluent Americans, those bigger debt loads can trigger financial crises, according to a 2010 paper by economists Michael Kumhof and Romain Ranciere of the International Monetary Fund.
Narrowing the rich-poor gap is “my highest priority,” Obama said in a July 30 speech in Chattanooga, Tennessee.
The president has long spoken of the need to escape an era characterized by the excesses of the 1990s dot-com bubble and the unsustainable housing boom of the next decade -- what former White House economic adviser Jared Bernstein calls a “shampoo economy: bubble, rinse, repeat.”
On Aug. 6, discussing the rebound in housing markets, Obama said: “As home prices rise, we can’t just re-inflate another housing bubble.”
Three days later, he said during a White House press conference that he wants a Fed chairman who “makes sure that we’re not seeing artificial bubbles.”
The statement was meant to “describe to you what he thinks the next Fed chair will have to grapple with in that job” and wasn’t intended as a specific warning, Josh Earnest, a White House spokesman, told reporters last week.
Both the White House and Fed have acted to prevent another bubble. 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.
The 2010 Dodd-Frank legislation created the Financial Stability Oversight Council, which is charged with detecting emerging risks.
“What’s been implicit in his comments is the idea that this has been very damaging in the past,” Bernstein said of Obama. “Dodd-Frank is in place to try to provide the needed oversight, and we better keep our eyes open.”
Posen, now president of the Peterson Institute for International Economics, says he’s concerned that premature bubble concerns could tilt the president’s decision toward naming a Fed chairman who’d be less likely to aggressively use monetary policy tools. “There is a real danger if the president gets caught up chasing this ghost,” he said.
As evidence that the economy remains feeble, Posen cites the money supply. The broadest measure of how fast funds are moving through the economy remains at its lowest level at least five decades, according to data compiled by Bloomberg.
Some investors, such as Mohamed El-Erian, Pimco’s co-chief executive officer, argue that a bubble may be emerging. “We see artificial pricing in virtually every asset class,” he said.
Home prices are up more than 12 percent from a year ago, according to the S&P/Case-Shiller Composite 20-city home price index. Recent increases have lifted prices, which had been about 10 percent below fair value “back into the approximate neighborhood of fair valuation,” Jerome Powell, a member of the Fed’s Board of Governors, said in a June 27 speech.
The president’s concerns also are evident in appointments to economic-policymaking posts. In February, Jeremy Stein, a Fed governor Obama named to his post in 2011, warned of potential “overheating” in credit markets.
“A prolonged period of low interest rates, of the sort we are experiencing today, can create incentives for agents to take on greater duration or credit risks, or to employ additional financial leverage,” Stein said.
The extra yield investors demand to hold speculative-grade or junk bonds rather than investment-grade corporate debt has narrowed over the past year from more than 4 percentage points to 3.2 percentage points, according to the Bank of America Merrill Lynch’s US High Yield Master II Index.
Sarah Bloom Raskin, a Fed governor nominated by Obama to be deputy Treasury secretary, highlighted the need for regulatory policy to prevent the emergence of asset bubbles and make the financial system more resilient.
“Asset bubbles are a feature of our financial landscape,” she said at a Washington luncheon in July. “What happened before could happen again.”