The Fed's Systemic-Risk Balancing Act

Using 'macroprudential' tools means recognizing the breadth of the potential trouble in the financial system.

By Martin Feldstein And Robert Rubin

Aug. 11, 2014 7:31 p.m. ET

The Federal Reserve Board of Governors recently warned of the possibility of excesses in asset markets but concluded that, at least for now, if there is a need to act it will not be done by raising interest rates but by relying on "macroprudential" policy tools to reduce systemic risk.

We are not expressing a view on whether there are current financial excesses that are potentially destabilizing—that is always hard to judge—or whether the Fed should raise rates now to deal with such possible risks. But we do think it imperative that Fed policy makers have a realistic view of the breadth of the possible systemic risks and of the tools that are available to deal with such risks.

The macroprudential tools that the Fed has discussed relate primarily to making banks more resilient, and that is obviously very important. But the possible systemic risks extend to a vast number of other institutions and asset markets, and there the issues around macroprudential regulation become much more complicated.

The Financial Stability Oversight Council, established in 2010 by Dodd-Frank, can give the Fed authority over certain non-banks, and can recommend policy changes to regulators like the Securities and Exchange Commission and the Commodity Futures Trading Commission. But so far the FSOC has taken very limited actions

The Fed's banking regulatory powers may also give the Fed the ability to indirectly affect some other areas of risk, such as hedge-fund positioning, but how much is unclear. Neither the Fed nor any other regulatory body has laid out a comprehensive description of the potential macroprudential tools.

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Thus, we see three important issues with respect to relying on macroprudential tools. First, since a wide range of assets and asset holders are involved, current tools are not nearly as broad and comprehensive as the existing range of systemic risks

Second, the situations are complex, making the design of an appropriate regime complicated and time consuming. Third, it might take considerable time for the FSOC and the relevant agencies to reach a decision to act.

There is debate about how much the extremely low yield on 10-year U.S. Treasury bonds has been affected by the Fed's "unconventional monetary policies," including both the quantitative easing and the long-term guidance of short rates. In addition to Fed policy, the low yields on Treasury bonds reflect weak investment demand by businesses, the slow pace of the recovery, and the dollar's role as a safe haven in a troubled world.

Whatever the reason, the low yields on Treasury bonds have led to reaching for yield in many ways and in very large magnitudes. Again this needn't mean that the asset prices are excessive, but the combination of their dramatic increase in price, the low volatility and the reaching for yield by investors and lenders suggest that the risk of excesses and the consequent instability have increased substantially. And if there are excesses, they represent wide-ranging systemic risks that go beyond the banking system.

There are many potential examples of heightened risks. For one, if hedge funds hold excessively priced assets that at some point start to adjust, there could be contagion and a snowballing effect, especially given the crowded trades that are common among hedge funds. That could affect broader markets and the economy more generally.

The yield spreads on low-quality "junk" bonds have fallen dramatically. The volume of high-risk "leveraged loans" (i.e., loans that require interest rates of Libor, the London Interbank Offered Rate, plus 200 basis points or more) have increased from $200 billion in 2010 to $600 billion last year. Covenant-light loans have grown from $10 billion in 2010 to more than $250 billion last year. The S&P 500 is near record highs. Volatility across asset classes is very low and volatility instruments like the Vix index of equity volatility are trading at low prices to reflect this. European sovereign-debt yields have come way down, with the Spanish 10-year bond, for example, recently trading at the lowest rate since 1789. And the list goes on.

The buyers of these instruments and securities include insurance companies, endowments, money managers, hedge funds, individuals, pensions, special funds created for their acquisition, and others.

In the short run, markets tend to be psychological and in the longer run tend to reflect fundamentals. 
Whether and how much markets are mispriced relative to fundamentals is always uncertain. But when markets have moved across the board as much as they now have, that should be a warning of the possibility of excesses.

Our conclusion is not that the Fed should respond to those risks by raising interest rates now. Weak labor markets are and should be a deep concern and a pressing issue

But the Fed should also take into consideration the possibility of excesses brought on by low interest rates that could create financial crises. In making interest-rate decisions, the Fed should have a realistic view of the broad range of the existing systemic risks and of the limits of the government's currently extant macroprudential tools.

The stress in these interest-rate decisions is heightened by the political system's failure to act on our nation's broader policy challenges, increasing the pressure on monetary policy, despite the limits on what it can do and the risks its expanded use can pose.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of the Journal's board of contributors. Mr. Rubin, a former U.S. Treasury secretary, is co-chairman of the Council on Foreign Relations. 

A Great Breakdown?

Kemal Derviş

AUG 11, 2014
World War I trenches

ISTANBUL This month – the centenary of the outbreak of World War I – is an opportune time to reflect on big risks. As Michael Spence recently warned, the international order’s widening security deficit, reflecting the weakening of whatever global governance we have, is fast becoming the biggest risk facing the world economy. The same point could have been made a century ago.

On July 30, 1914, Austrian warships bombarded Belgrade, five weeks after the assassination of Archduke Franz Ferdinand in Sarajevo. By mid-August, the world was at war. The armistice that was agreed four years later, after about 20 million people had died, amounted only to an interlude before the horror of World War II.

In the years preceding August 1914, until the assassination of the archduke, the global economy performed relatively well: trade expanded worldwide, financial markets seemed healthy, and the business community shrugged off political problems as either temporary or irrelevant. It was a political breakdown that led to three terrible decades for the world economy.

Markets and economic activity can withstand a great deal of political stress and uncertaintyup to the point that the international order breaks down. Today, for example, the economic mood is rather upbeat. The International Monetary Fund forecasts 4% growth for the world economy in 2015, while stock-market indices are up in many parts of the world; indeed, the Dow Jones reached an all-time high in July.

In the last few months, however, a civilian airliner was downed in eastern Ukraine by a sophisticated Russian-made missile, tensions have increased around disputed islands in the South and East China Seas, and chaos in the Middle East has continued to spread. The Israeli-Palestinian conflict is in one of its worst phases in decades, with the renewed frustration unleashed by the massive loss of civilian life in Gaza likely to encourage extreme reactions. Terrorists may be on the verge of designing much less detectable weapons.

There are other, lesspoliticaldangers. West Africa is afflicted by a terrible outbreak of the deadly Ebola virus, which will kill thousands of people. The outbreak has so far remained regional, but it serves as a reminder that in an age of air travel by millions, no one is safe from the spread of infectious disease. Containing a disease or a terrorist threat by curtailing international travel or transport would devastate the world economy.

Thinking about August 1914 should remind us that great catastrophes can materialize gradually. Leaders can be sleepwalkers who fail to manage risk by, say, establishing institutions that can channel the rival interests and claims that fuel international conflict. Such sleepwalking by policymakers caused the financial meltdown of 2008 as well. Its consequences were not as deadly, though the political effects of mass unemployment and the heightened perception of economic insecurity are still with us.

These examples should spur the world to find ways forward for cooperative action. But the opposite appears to be happening

The United Nations seems more paralyzed than ever. The US Congress still has not approved the IMF reform package agreed in 2010, weakening one of the most important international institutions. Partly because the United States makes capital increases and governance reforms in global financial institutions so difficult, the BRICS countries (Brazil, Russia, India, China, and South Africa) have launched their own development bank, to be based in Shanghai.

Likewise, instead of providing a shining example of supranational cooperation and pooled sovereignty for the twenty-first century, the European Union remains mired in rather petty disputes. While it still cannot fully agree on the design of its banking union, it is allowing Prime Minister Viktor Orbán of Hungary, a member country, to denigrate the democratic and liberal values upon which the EU rests.

The way forward cannot be a return to the past, with its clashing nation-states. The future can be secured only by strong cooperation among all those committed to liberal democracy and the rule of law, with no double standards or excuses, and by patient strengthening of international institutions that embody these values and can translate them into practice.

Whenever a global or regional power acts in a way that contradicts these values, or allies itself closely with those who do, it undermines the international order, which should deliver security and increasing prosperity (and to some degree has). The global economy holds great promise, but it is a promise that can be realized only in an international system based on rules, consent, respect, and a shared sense of justice.

The fact that neither the mayhem in the Middle East nor the crisis in Ukraine seem to touch financial markets should not lull us into complacency. The memory of August 1914 should remind us how the world stumbled into catastrophe. As we know – or should know – from the example of climate change, big risks must be managed, even if the probability of worse-case outcomes is low.

Kemal Derviş, former Minister of Economic Affairs of Turkey and former Administrator for the United Nations Development Program (UNDP), is a vice president of the Brookings Institution.

August 12, 2014 10:48 am

War-weary America has to show its steel in Iraq

Isis has an agenda and a growing foothold in Syria and Iraq, writes Richard Haass

What the world saw last Thursday evening was an American president torn between personal preferences and cold reality. The result is a US that is once more moving towards greater military involvement in Iraq – but only reluctantly and incrementally.

Describing himself as someone who ran for officein part to end our war in Iraq and welcome our troops home”, Barack Obama announced a policy of dropping supplies to save thousands of members of the Iraqi Yazidi religious minority – and authorised but did not order air strikes on advancing insurgents from the Islamic State of Iraq and the Levant (known as Isis).

He deployed humanitarian terms (“to prevent a potential act of genocide”) as well as self-interest (“to protect our American personnel”). Conspicuously absent was any strategic rationale, and longer-term plan, for US action.

The announced policy may provide relief to the Yazidis desperate for food and water and, with its narrow parameters, to Americans desperate to avoid renewed entanglement in what The New York Times described as “that graveyard of American ambition”. Any such relief will be shortlived given the nature of US interests and the threats against them. Indeed, the first air strikes against Isis positions near the city of Erbil, the Kurdistan Regional Government’s capital in northern Iraq, came 12 hours later.

Isis is more of a threat than al-Qaeda, which was and is mostly content to destroy. Isis has an agenda: to create a caliphate based on what it views as a return to pure Islam over swaths of the Middle East and beyond.

It has a growing foothold in Syria and Iraq. At some point it will train its guns on Jordan, Lebanon and others. This would constitute not just a humanitarian but a strategic nightmare in a region whose energy resources remain vital to the world’s economy.

What is more, success would feed ambition: it would only be a matter of time before foreign Isis fighters returned home and threatened the security of Europe and the US from within.

It is fantasy to think that the Iraqi government and its military can stop Isis on their own. Isis has zeal and momentum; Iraq is beset by division, corruption and incompetence. The power struggle among three menIraq’s president Fouad Massoum; Haider al-Abadi, whom he has designated prime minister; and Nouri al-Maliki, who had held that office since 2006 – both reflects and adds to the country’s disarray.

What should be done? The US should carry out sustained attacks on Isis in both Iraq and Syria. The border is irrelevant; what is essential is that Isis is slowed and weakened.

Economic and especially military aid to the Kurds holding the line against Isis should be increased and sped up. It is pointless to object that this will weaken the integrity of Iraq. That horse has left the barn. Kurdish independence is a reality that needs to be accepted. Rump Iraq is largely under the sway of Tehran, not a balance to Iranian power but a vehicle. The goal should be to stop Isis but to do so in a manner that avoids making Iran the beneficiary.

The weakening of Isis in Syria may provide an opening for the regime of Bashar al-Assad to strengthen its position. This would be unfortunate but not as bad as Isis strengthening its position in Syria. That said, the weakening of Isis may offer a chance to bolster (using arms and intelligence) any remaining moderate alternatives to the regime.

It is also time to shore up Jordan, which must prepare to defend itself while struggling under the weight of an enormous refugee burden.

Above all, Mr Obama needs to articulate what the US is doing and why. He must explain why isolationism makes no more sense now than at other times in modern US history.

A course of action along the lines suggested here will not repeat questionable attempts at nation-building. It will not require ground troops. Rather, it will use air power for what it is designed to do: weaken an adversary and force it on to the defensive. Others, including Kurds and Iraqis, will need to provide ground forces.

Mr Obama and those around him might also rethink America’s role. They tend to exaggerate the costs and risks of acting, and discount those of inaction.

Yes, the 2003 Iraq war was an ill-advised, poorly executed war of choice. But also ill advised was not pressing harder for US troops to remain; the president described this criticism as “bogus and wrong”, but a residual force of 10,000 US military advisers and trainers would have enhanced Iraq’s military capacities and damped political infighting.

A bigger error was calling for regime change in Syria then doing little to bring it about. The ensuing civil war, the lack of aid for relatively moderate opponents of the regime, the failure to attack the regime when it used chemical weaponsall created a vacuum exploited by Isis.

The  president said people the world over look to America to lead. He is right. Now is one of those times.

The writer is president of the Council on Foreign Relations and author of ‘War of Necessity, War of Choice: A Memoir of Two Iraq Wars’

Copyright The Financial Times Limited 2014.