Source of instability.

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Who's Responsible for the Next Crisis

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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Critics of the U.S. Federal Reserve often argue that its monetary stimulus efforts are creating the possibility of dangerous instability in financial and housing markets. They should focus their concerns on Congress instead.

Despite a long period of extremely low interest rates, it's hard to see any signs of impending financial instability in the U.S. True, price-to-earnings ratios in the stock market are somewhat high by historical standards. But, as the economists Olivier Blanchard and Joseph Gagnon have noted, the stock prices are a logical result of the very low yields in the bond market, rather than a signal that investors are unduly willing to take on risk. 

Could instability arise later? History offers a great deal of comfort. The Fed held short-term yields very low during the 1930s without incident. The Bank of Japan has kept rates extraordinarily low for the past two decades without inflating a bubble. As I document here, even the housing boom that preceded the Great Recession began in the 1990s, during a period of relatively high interest rates. So there's little evidence to support the view that current low-interest-rate policies will trigger a major bout of instability.

That said, there is reason for concern -- about the plethora of ways in which Congress subsidizes debt. We know from painful experience how excessive borrowing, or leverage, contributes to episodes of financial instability. Yet the federal government seems be doing everything it can to encourage leverage. It has made interest payments on corporate and mortgage debt tax-deductible. It makes 30-year mortgages possible by absorbing most of the risk. It provides student loans at below-market rates. It subsidizes bank leverage by providing explicit guarantees to depositors and (at least arguably) providing implicit guarantees to other bank creditors.

All of these examples illustrate a broader problem. If the government thinks the private market is failing to provide enough of something, such as college education, the right response is to subsidize it directly. Instead, Congress invariably chooses to subsidize borrowing for that activity. As a result, the U.S. has become an over-leveraged nation, and an over-leveraged nation is more prone to financial instability.

To be clear: In today's global economy, where inadequate demand for goods and services has left too many people out of work and underpaid, governments should subsidize private consumption and investment. My point is that those subsidies should not run through debt finance.

We saw in 2008 what a financial crisis can do. We should want our government to reduce the likelihood of a repeat. There is little theory or evidence to suggest that raising interest rates now would help. Instead, our government needs to stop encouraging excessive borrowing.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net