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Wednesday, 7 October 2009

Is the Next Bubble Unavoidable?

From The Business Insider, Oct. 6, 2009:

The Federal Reserve is now faced with a challenge that is akin to threading a needle by throwing a spool of thread across a football field. It is attempting to keep loose money and quantitative easing policies in place long enough not to stymie the nascent recovery while pulling them back in time to avoid massive inflation. It's a Hail Mary pass with an impossibly small target while facing a blitz.

In today's Wall Street Journal, Nouriel Roubini and Ian Bremmer lay out a series of policy prescriptions for how they think the Fed might be able to avoid creating another dangerous asset bubble without triggering a double-dip recession. They are very clear that this is an enormously difficult task--but even their assessment might be too optimistic.

Here's the problem. They agree that the operations of the Federal Reserve need to be subject to political review because it is clear that the New York Fed has been captured by Wall Street. The Fed's worries about its independence being compromised make no sense when it seems that its independence is already compromised to the our powerful financial firms.

But Congressional oversight is likely to result in pressure to keep monetary policy too loose for too long. Pulling back on easy money when the financial system recovers but the real economy is still shaky, will elicit howls of protests from politicians whose constituents are still out of work, loosing their homes and seeing their credit lines closed. There will be intense political pressure to repeat the "fateful mistake" of the last recession, keeping monetary policy too easy for too long.

Roubini and Bremmer's way out of this trap is to recommend better supervision of banks, including the creating of a new insolvency regime for the most important financial institutions and better capital requirements. This too is harder than it looks. Politicians, especially in Europe, are more attracted to regulating banks through regulating pay than the complex and costly job of reforming capital requirements. And policies that regulate 'too big to fail' institutions run the risk of creating the impression of a government guarantee.

Is there are way out? Unfortunately, the way out may be the way back. The government, including the Fed, need to restore the credibility of market processes by letting a too big to fail institution go insolvent. In short, we need another Lehman. And a policy that depends on failure to succeed is certainly not a happy one.

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