In October 1925, Walter W. Stewart, the Director of Research at the Federal Reserve Board, proposed reducing speculation by member banks pressuring credit to banks lending to brokerage firms. Benjamin Strong, the President of the NY Fed, opposed the idea.
Several years later (1928), Adolph Miller, then the Fed Board’s economist, suggested a meeting of NY Banks, for the purpose of commanding an end to their financing of speculation. Ben Strong’s successor at the NY Fed, George Harrison, also told the Board in February 1929 that growth of credit in the banking system was far too great relative to total business activity.
The NY Fed opposed any action. As described in The Great Contraction (1929-1933), they enlisted Treasury Secretary Andrew Mellon to help make its case. The NY Bank was successful, and there was no intervention to reduce excess speculation. We obviously don’t know how successful these efforts might have been otherwise, but we do know what happened: The 1929 crash, and the Great Depression.
Fast forward 70 years: Alan Greenspan complained that it is too difficult to identify bubbles in real time, and the Fed does not have the ability to safely pop them regardless. He famously stated that it would be easier to clean-up the mess after an asset bubble pops than to try and deflate the bubble on the way up.
As we saw in several articles last week, the Fed is rethinking its stance on popping bubbles. It is significant that the Fed at least be aware of their own behavior, and how it contributes to bubble formation and growth. At the very least, they need to understand how Fed policy can lead to the inflation of bubbles in the first place.
Despite Greenspan’s defenses, there are quite a few signs the Fed should look for when attempting to identify asset bubbles, in order to reduce the risk of implosion. Consider these 10 elements to identifying bubbles in real time that the Fed, or anyone else for that matter, can use:
1. Standard Deviations of Valuation: Look for traditional metrics — valuations, P/E, price to sales, etc. — to rise two, then three standard deviations away from the historical mean.
2. Significantly elevated returns: The S&P500 returns in the 1990s were far beyond what one could reasonably expect. Consider the years around Greenspan’s "Irrational Exuberance" speech:
And the Nasdaq numbers were even better.
3. Excess leverage: Every great financial crisis has at its root easy money and rampant speculation. Find the leverage, and speculation wont be too far behind.
4. New financial products: This is not a sufficient condition for bubble, but it seems that every major bubble has somewhere in the mix, new products. It may be Index funds, derivatives, tulips, 2/28 Arms.
5. Expansion of Credit: With lots of money floating around, we eventually get around to funding the public. From Credit cards to HELOCs, the 20th century was when the public was invited to leverage up also.
6. Trading Volumes Spike: We saw it in equities, we saw it in derivatives, and we’ve seen it in houses: The transaction volumes in every major boom and bust, by definition, rise dramatically.
7. Perverse Incentives: Where you have unaligned incentives between corporate employees and shareholders, you get perverse results — like 300 mortgage companies blowing themselves up.
8. Tortured rationalizations: Look for absurd explanations for the new paradigm: Price to Clicks ratio, aggregating eyeballs, Dow 36,000.
9. Unintended Consequences: All legislation has unexpected and unwanted side effects. What recent (or not so recent) laws may have created an unexpected and bizarre result?
10. Employment trends: A big increase in a given field — real estate brokers, day traders, etc. — may be a clue as to a developing bubble.
While we can debate whether or not the Fed should intervene by popping
bubbles, we can all agree that, at the very least, they should not
contribute to bubble inflation . . .
Update: October 22, 2008 5:02pm
–Low credit spreads (indicative of fixed income risk appetites running
too high)–Low and falling lending standards (forward indicator of credit trouble
ahead)–Very low default rates on corporate and high yield bonds (indicates the
ease with which even poorly run companies can refinance and creates false sense
of security)–Low equity volatility readings over an extended period (indicates
equity investor complacency)
Fed Rethinks Stance on Popping Bubbles
WSJ, OCTOBER 17, 2008
Central Banks Reconsider Doctrine of Preemption
Bloomberg, Oct. 15 2008