America's Risky Recovery

Martin Feldstein discusses that while the U.S. is almost reaching full employment thanks to the Fed's monetary policies, the low interest rates have incentivized investors to take excessive risks that are unhealthy for the economy. He also discusses how the U.S. does not have any existing macroprudential policies and suggests that the Fed needs to increase the interest rates.

"The low-interest-rate environment has also caused lenders to take extra risks in order to sustain profits. Banks and other lenders are extending credit to lower-quality borrowers, to borrowers with large quantities of existing debt, and as loans with fewer conditions on borrowers (so-called “covenant-lite loans”).

Moreover, low interest rates have created a new problem: liquidity mismatch. Favorable borrowing costs have fueled an enormous increase in the issuance of corporate bonds, many of which are held in bond mutual funds or exchange-traded funds (ETFs). These funds’ investors believe – correctly – that they have complete liquidity. They can demand cash on a day’s notice. But, in that case, the mutual funds and ETFs have to sell those corporate bonds. It is not clear who the buyers will be, especially since the 2010 Dodd-Frank financial-reform legislation restricted what banks can do and increased their capital requirements, which has raised the cost of holding bonds.

Although there is talk about offsetting these risks with macroprudential policies, no such policies exist in the US, except for the increased capital requirements that have been imposed on commercial banks. There are no policies to reduce risks in shadow banks, insurance companies, or mutual funds." 

On a similar note, Simon Johnson discusses that we are potentially moving towards another financial crisis as loopholes that cause the 2008 financial crisis have not been closed:

"Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, publishes his own calculation of capital levels at the world’s largest banks, and these data are now available through the end of 2014. The most leveraged big US bank, Morgan Stanley, has less than 4% equity, meaning that 96% of its balance sheet is some form of debt. The average for big US banks is just under 5% equity.

This is more – but not much more – capital than some troubled banks had in the run-up to the financial crisis in 2008. Citigroup, for example, had no more than 4.3% equity, according to Hoenig’s calculation, in November 2008. At the end of 2012, when Hoenig started to publish his US GAAP-IFRS adjustment, the average for the largest US banks was roughly 4% equity. It is possible to argue that this key measure is moving in the right direction, but the pace of improvement is glacial at best.

More important, 5% equity is unlikely to be enough to absorb the kinds of losses that a highly volatile world will throw up. Some major shocks could come from unexpected quarters. For example, assets may prove less liquid than investors suppose, as happened with money market funds in 2008; today, skeptics worry about exchange-traded funds (ETFs). Or overly complex securities could become hard to price. It is a red flag when people selling collateralized loan obligations today cannot fully explain the risks involved.

Or perhaps the shock will affect sovereign-debt values in faraway places, as happened in 1982. It is striking that no experts – public or private – really have a firm grip on what could happen if there is another round of difficulties with Greek government debt."

As we read Piketty, it is important to reflect on the accumulation of capital and its risks, the impact of rich countries and the increasing income gap especially when our financial structures are prone to risks.

Thought I should link back to Bernanke and Wolf!