The Blind Interviewing The Blind; Or, Bubble Time

By Jeffrey Snider

At the end of last month, the Brookings Institute hosted a conversationwhere one of their most distinguished current scholars introduced and interviewed one of their newest. The former was former Federal Reserve Chairman Ben Bernanke welcoming the latter, former Federal Reserve Chairman Janet Yellen. Listening to them talk was a total delight (thanks T. Tatteo for that), particularly for all the obvious things they almost certainly skipped over intentionally.

If you have the time, it’s worth it in the same way as it is to read through the 2008 FOMC transcripts. Should anyone really need to be convinced they really have no idea what they are doing, this is a pretty good opportunity. It’s one thing to hear about deep economic theory for what hasn’t happened yet; quite another knowing what did happen and how these two people more than any others in the world were supposed to have prevented it.

Instead, they remember 2008 a little differently:

And certainly, by 2008 and after Lehman, even though later on there was another surge in oil prices that took inflation up, we had a real economic situation that was simply becoming so dire that to my mind there was no question that that as the dominant matter of concern. And that if unemployment rose to the levels it looked likely to rise to, and I think we’re lucky it rose no higher than 10 percent, I think if you hadn’t done all of the interventions that you supported, god knows what would have happened to unemployment.

Yeah, no. The 2008 transcripts display a much different picture as to how officials really thought things were evolving particularly after Bear Stearns (a lot more cautious optimism than she seems to remember; they didn’t even forecast a recession in the Greenbook until afterLehman). If they really had any idea, why at the end of February 2018 is Janet Yellen congratulating Ben Bernanke for what amounts to “jobs saved” after the worst monetary crisis in four generations?

That’s not what struck my interest, though. During the Q&A portion, Yellen was asked about the dot-com stock bubble (which, she recalls, everyone at the Fed knew it was a bubble all along as if the meeting transcripts of that era don’t exist, either).

MS. YELLEN: So, I mean, we certainly had a stock market bubble. It burst and, when it burst, it caused a recession. It did not cause a financial crisis. There were people who lost money. There were macro consequences from it. The economy recovered reasonably well from that recession. It wasn’t that deep, you know. It was an event that had a sufficient macro consequence, and it caused a recession…

And I guess I would agree with the general conclusion that’s incorporated in last week’s monetary policy report, which is that we have a much stronger financial system. It’s well capitalized, has a lot of liquidity, has relatively little exposure to declining equity prices. We stress test — we do regular stress testing and look, for example, in that stress test for what the consequence would be of sharp declines in commercial real estate prices.

The dot-com bust, like the Crash of ’87 or LTCM and the Asian flu, produced only mild economic fluctuations. By contrast, the housing bubble got real bad, real fast. Is it true what Yellen now claims, that “we have a much stronger financial system”, one that “has a lot of liquidity?”

Experience over the last ten years would suggest otherwise, including and especially the constant inflation debacle (not that we need 2% inflation, but it was both Yellen and Bernanke who were instrumental in making that number an explicit monetary target, which is what matters). My point is, and what is relevant for today, how would Janet Yellen know?

Here’s what she said in mildly recalling her role in 2008:

I think what I failed to appreciate was, what if housing prices began to fall? I just really did not understand how vulnerable the financial system and particularly the shadow banking system was, how leveraged it was, how much maturity transformation there was, how much of this risk that we thought was being disbursed through the economy was really remaining on the books of these institutions.

So I wrongly thought if housing prices fell a medium amount it would do damage to the economy and the outlook, but it would not destroy the core of the financial system. And I think that was a failure to appreciate the weaknesses.

Huh? Falling home prices are not an isolated instance of an exogenous circumstance. To treat them that way, even after the fact, is almost certainly being purposefully obtuse. The real problem she briefly mentions, “I just really did not understand how vulnerable the financial system and particularly the shadow banking system was.” That was never really a housing issue, but a monetary one; the very role assigned to central bank heads like Ben Bernanke and Janet Yellen.

So, if she had no idea about the shadows in 2008, then how can she claim ““we have a much stronger financial system”, one that “has a lot of liquidity?” Does anyone really believe Janet Yellen has learned from all the massive mistakes? That was, essentially, the irony of their gettogether here; it was entirely and purposefully about avoiding that very topic.

Thus, the conditions of today are very much like 1999 except for that one vitally important difference. Eighteen years ago, the dot-com bubble popped and did mild damage with the eurodollar system fully behind it (the shadows). If the current stock bubble pops, which now the out-of-office-Yellen suddenly realizes valuations aren’t ideal, she says it won’t matter much because “we have a much stronger financial system”, one that “has a lot of liquidity.”

That’s the problem. They think there is liquidity when the last ten years have proven they wouldn’t know if there was. What really happens if we repeat 1999 only this time without the liquidity and financial strength once provided by the shadows?

Yellen claims there is little exposure between banking and stock prices, and she’s right. But so what? That’s not the bubble issue. It’s what a reversing stock market might portend for systemic perceptions of risk – the very issue of falling home prices. Though that episode was more directly involved in global liquidity, there are similar proxies today where the line between risk perception and functional settings is more direct; i.e., corporate junk, including not just domestic but also European and EM. What is up with the Chinese, after all?

Ten years later, and “we’ve” learned nothing. That condition by itself proposes a far more substantial downside profile. Not to beat my own dead horse, but yield curve after all.

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