Fed’s targeting of asset bubbles leads to contradictions

On July 15 the head of the U.S. Federal Reserve, Janet Yellen, announced during a Senate hearing about the current economic outlook that certain asset markets were overvalued. The charges mark a potential revolution in how central banks across the world will conduct their affairs. In her testimony, Yellen noted that valuations for low-rated “junk bonds” or corporate debt “appear stretched,” while “issuance has been brisk.” Similarly, in its full monetary policy report released the same day, the Fed said stocks for some social media and biotech industries appear significantly overvalued.

Much of this was not surprising. For months, commentators had said these trends of high valuation in risky and overvalued markets are unsustainable. But such confirmation from the most powerful banker in the world dramatically alters how central banks see themselves. Following the 2008 financial crisis, many central banks turned their focus to managing the financial market in a far more concerted manner than they did previously. For example, the banks intervened in the market to prop up asset prices by increasing the monetary base in the banking system and thus lowering interest rates, but it seems that they will now try to stop these prices from rising to levels they consider dangerous.

Yellen’s comments were a stern warning to participants in these markets that they might be getting out of hand. While the results have largely been mixed, it is not yet clear whether it will actually cool prices in high-yield bond markets. For example, the market for “junk” bonds has since taken a substantial hit, whereas some social media companies’ stocks have fared better. Twitter shares have not declined in price; Facebook’s shares have actually increased, elevating the wealth of its chairman and CEO, Mark Zuckerberg, to $33.3 billion.

If its latest warnings do not work, the Fed might have to look at alternative approaches. Economist Thomas Palley has proposed one such idea: Urge central banks to force companies to back their assets with reserve cash. By raising the reserve requirements on these assets, central banks could choke off demand for specific assets. Palley’s “asset-based reserve requirements” proposal would extend the central banks’ ability to set interest rates on overnight funds to all markets. The banks would maintain, in the form of reserve requirements on different asset classes, as many levers on hand as markets they regulate, giving them the power to act if they think a particular asset market is overheating.

But Palley’s approach has some flaws. First, for nearly two decades speculative asset bubbles have propped up many Western economies, including that of the U.S. For instance, Bill Clinton’s presidency oversaw the dot-com bubble, while George W. Bush’s administration faced a housing bubble. These bubbles were necessary to maintain demand for goods and services because wages have remained stagnant in relation to productivity growth for decades. As a result, while there are more goods and services in the economy to spend money on, most people have not seen their purchasing power grow. Asset- and debt-fueled bubbles are needed to ensure that economic growth ticks over at a level high enough to keep unemployment relatively low. During the Clinton and Bush years, the then–head of the Federal Reserve, Alan Greenspan, politely ignored these bubbles. He took a “mop up afterward” approach, meaning that he let bubbles run their course and then tried to fix the problems created when they burst by lowering interest rates. But after the 2008 crisis, many central banks, the Fed included, saw that this was no longer tenable.

This leads to a contradiction between various goals being pursued by the Federal Reserve and other central banks. On the one hand, central banks seek to ensure full employment, while they also seek to contain speculation in the financial and housing markets. But if full employment requires speculative bubbles in the financial and housing markets, the central banks are left in a very difficult position. Unfortunately, this is not a problem they can solve alone.

There are only two ways that major economies can secure full employment without relying on speculative bubbles. The first is for governments to run higher budget deficits. Governments can spend this money in a variety of different ways. They might engage in a public works program, give out extensive tax cuts to working families or adopt a basic income guarantee or a jobs guarantee. Second, and more important, full employment could be achieved by reducing the prevailing wealth inequality. When working people are compensated fairly for their labor, they spend their earnings on the goods and services they produce. This will create full employment because people will spend the money they earn and buttress demand and, hence, employment. But when few people at the top end of the income spectrum accumulate most of the wealth in society, they do not spend it. Instead, they speculate in the financial markets, and thus the economy must rely on asset bubbles to secure low unemployment.

The task of reducing wealth inequality is an enormous one. In fact, it amounts to nothing short of reconstituting the middle class. Running large government deficits is a good place to start because in addition to ensuring full employment, it gives working people more bargaining power vis-à-vis their employers. But this will not be enough. Governments need to promote unionization among working people by passing laws that make organizing easier and by countering the virulent anti-union culture that has grown in many countries since the 1980s. Unions are the foundation on which the middle class is built and without which it would crumble into rubble.

Increasing unionization and diminishing wealth inequality will be a long struggle. But it is a necessary one. The central banks can play a key role by curbing speculative excesses and promoting studies that link income inequality to high rates of unemployment and low unionization rates. Those working in central banks should discuss these issues with government officials in private and also make public pronouncements to encourage more debate.

Earlier this year Sen. Bernie Sanders, I-Vt., asked Yellen whether the U.S. is a capitalist democracy or an oligarchy. Yellen declined to “give labels” but said the statistics Sanders cited on income inequality “greatly concerned” her. This is a good start. But it might be time for central banks to be more aggressive in linking economic stagnation to income inequality, and income inequality to high unemployment and low unionization rates.