Governor Stein’s Doubts - I: Overheating in credit markets

Governor Stein pointed out that a lengthy period of low interest rates confirms an assumption of little risk. This encourages agents to increase financial leverage beyond what might be considered normal or even sane. Borrowers must work within the income budget and not borrow simply because it is easy to service the loan

Copper or better known as Dr Copper is diagnosing something serious. Copper prices are often considered a proxy for the health of the global economy and prices are down. They have fallen by 5% in the last month and are well off their highs of 2012 and 30% lower than 2011. Inventories have more than doubled in three months, the fastest rise since demand crashed in 2008. Besides copper, earnings of European equities are also down. Fourth-quarter profits at European companies fell 5.2% from a year earlier while revenue inched up just 0.5%. Analysts’ forecasts last fall were for 15% growth. They now forecast just 5% growth. Yet despite the gloom in equities in both Europe and the US are reaching new highs. The obvious reason is the enduring faith in central banks to provide as much money as it takes for as long as it takes. But are there some risks to this strategy? One of those central bankers certainly thinks so.


Dr Jeremy C Stein was, like chairman Ben Bernanke, a Harvard professor of economics when he was appointed to fill a vacancy on the board of governors of the US Federal Reserve. Last month, he gave a speech regarding overheating in credit markets. His remarks concerned an analysis of why markets experience credit booms that inevitably end in tears. His explanation cantered on the view that the main causes of these booms are institutions, agencies, and incentives, in short: the rules.


Part of the problem that economists have with credit markets is that the movements are not caused by the lenders themselves. Lenders are far more cautious with their money. Instead the risk is determined by agents in the financial community who are more interested in their own compensation rather than the amount of risk.


After every crash, institutions and regulators try to protect against excessive risk taking by developing a new set of rules. But the agents have very large incentives to discover vulnerabilities in the rules and take advantage of them in ways that may bring down their organizations or the whole economy. Determining episodes of overheating is a major problem. They cannot be precisely measured like unemployment or inflation. To help identify them, governor Stein proposed three factors.


The first is financial innovation. In the last crash, the new innovation of collateralized debt obligation (CDO) secured by sub-prime mortgages received a lot of the blame. When used properly many of these innovations can bring enormous benefit, but since they are new and unfamiliar to both the players and the regulators their risks are not obvious, while the benefits to the agents are.


The second factor is a change in the regulation. Regulations are usually aimed at one particular evil, but often the rules or the way they are administered can result in unintended consequences. This is especially true if the rules are meant to help reform a prior system in order to bring it up to date with the requirements of a modern economy. An untested rule changes the incentives and disincentives of any transaction. Old ways of doing business may no longer be profitable and new products, especially ones that can exploit loopholes, will come into existence. Slight changes to existing instruments can conform to a new system. If they enrich agents, they will be adopted and exploited very rapidly.


The third factor that governor Stein chose was something that must have raised the eyebrows of those among his fellow Federal Reserve members who have been advocating unlimited QE and interest rate suppression. He pointed to a change in the economic environment specifically using a prolonged period of low interest rates. A lengthy period of low interest rates confirms an assumption of little risk. This encourages agents to increase financial leverage beyond what might be considered normal or even sane.


The three factors, of course, work together. Financial innovation that takes advantage of changes in the regulatory environment helps to adapt old methods to a new economic situation. The incentives are always the same: to increase the benefits to the agents.

Governor Stein apparently does not share chairman Bernanke’s calm assumptions that the risks are minimal and can be dealt with. He wisely pointed out that the ways of investment bankers and other financial players can be deep and mysterious. One of the stated objects of interest rate suppression is to encourage risk. The problem is that no one really knows the extent or form that risk will take. These risks are “often taken in opaque ways that escape conventional measurement practices”. So, identifying even one potential risk could merely be the “tip of the iceberg”. This admonition is especially important in a global financial environment where rules and regulations are not coordinated. Quite the reverse. They are often created in competition with other rules allowing agents to shop jurisdictions to create risk instruments that conform to one set of rules only to be sold in another.


Governor Stein’s analysis would be unsettling in this environment created by central banks, but it is simply theoretical without a specific real world example. Governor Stein thought of one that could potentially bring down markets. He discussed this in his speech. But there was one other that he didn’t discuss.


In the second part of this essay next week I will discuss where these problems exist.


Other stories by William Gamble


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

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