Popper-in-Chief: President Obama Targets Asset Bubbles

Plant Money

At the end of July, the President Barack Obama outlined the first cornerstone of his vision for the American middle class at an Amazon (NASDAQ:AMZN) facility in Tennessee. During his speech, he emphasized that “a good job with good wages” is part of what it means to be middle class in the United States, and he advocated a policy that advanced the creation and maintenance of these jobs.

The next week, at Desert Vista High School in Phoenix, the president outlined the second cornerstone of his vision for the American middle class — “A home to call your own” — and proposed a series of steps to facilitate the housing recovery and guard against future crises.

“As home prices rise, we have to turn the page on the bubble-and-burst mentality that created this mess and build a housing system that’s rock solid and rewards responsibility for generations to come,” Obama said during his weekly address on August 10. “That means winding down the companies known and Fannie Mae and Freddie Mac, making sure private capital plays a bigger role in the mortgage market, and ending the era of expecting a bailout after your pursuit of profit puts the whole country at risk.”

It’s a tired metaphor (about as tired as the economy itself), but the U.S. is currently caught between a rock and a hard place. On the one hand, growth has been tediously slow. The advance estimate from the U.S. Bureau of Economic Analysis shows that gross domestic product increased at an annual rate of 1.7 percent in the second quarter of 2013. This is an improvement on the 1.1 percent growth experienced in the first quarter, but still well below the level of growth that many economists say is necessary to reduce long-term unemployment.

Forecasts compiled by the U.S. Federal Reserve indicate that gross domestic product growth will edge up to a range between 3 percent and 3.5 percent in 2014 and to a range between 3 percent and 3.7 percent in 2015 before leveling off to a range between 2.3 percent and 2.5 percent in the long run. Unemployment and inflation expectations are consistent with this growth forecast.

But growth has been slow — one again below trend, according to the Chicago Fed National Activity Index — and the longer the economy drags its feet, the more damage that’s done. Long-term unemployment remains elevated as does the headline rate at 7.4 percent, and price pressures remain minimal. The housing market has earned itself a reputation as a bastion of the recovery to date, but the entire economy can’t piggyback on low mortgage rates (read: easy money) forever.

Chicago Fed

Source: http://www.chicagofed.org/digital_assets/publications/cfnai/2013/cfnai_july2013.pdf

The other hand is the highly accommodative monetary position of the Fed. Benchmark rates trapped at the zero-bound coupled with massive stimulus in the form of quantitative easing has helped encourage business activity by effectively making money cheaper. QE reduced lending rates to record lows, which helped encourage not just corporate activity — something that can be demonstrated by the performance of equities over the past few years — but mortgage lending activity — something that can be demonstrated by historically low mortgage rates.

But the downside of this position on monetary policy is that it encourages risky financial behavior, and could help fuel the same types of asset bubbles that contributed to the catastrophe of the late 2000s financial crisis. Home prices, as the president has indicated, are rising. In some places, they have already surpassed their pre-crisis valuations, and this is in no small part due to the fact that mortgage rates are so low. People are trying to take advantage of the situation and lock in low rates while they can, despite lingering uncertainty.

This type of behavior is also evident in the market for financial products. The value of junk bonds — high risk, high yield securities — issued so far in 2013 is more than $240 billion, more than twice the level in 2007. Trading on margin has also increased over the past few years as the cost of money has remained low. This type of activity has provided fodder for arguments against easy-money policy, which has helped fuel artificially high valuations in many asset classes.

Obama seems to be aware of all of this, and is advocating alongside the various cornerstones of his vision for America’s middle class a policy framework that guards against the formation and damaging collapse of asset bubbles.

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