Doing the Same Thing Over and Over Again and Expecting Different ResultsBring the Financial System Back From the Bring of Insanity

Patrick Hagerty

AN APPEAL TO THE FEDERAL GOVERNMENT TO SAVE OUR PROSPERITY

Executive Summary

In February of this year the S&P 500 closed above 2,100 for the first time in

history. If you bought the S&P 500 same index on January 1st of last year you would have

made 12% by the time you rang in the new year and if you had listened to Warren Buffet

when he wrote his op-ed titled “Buy American. I am” in October of 2008, you would

have more than doubled your money by now. It is safe to say that we have left the Great

Recession behind and good times are ahead, but in 2006 many were saying the same

thing. The market has a way of fooling even the brightest minds in Washington and on

Wall Street, and it has made that fact clear countless times in the past. The only thing we

can do is to pay attention and be prepared to take action if crisis occurs.

The best way to prepare ourselves is to learn from past mistakes. Every economic

environment is unique in its own ways but there are also always similarities. Right now

the Federal Reserve is dealing with the low interest rates created by the subprime

mortgage crisis recover efforts. Now that the financial markets have recovered it is time

to change our mindset from recovery to sustainability. The financial crisis hurt everyone,

but the recovery left low and middle-income individuals behind as the income inequality

gap continued to grow. In order to achieve a truly sustainable economy the Federal

Reserve needs to stop giving Wall Street preferential treatment and help the masses. Now

that quantitative easing is over, the Federal Reserve needs to use its monetary stimulus

powers to create real wage growth on Main Street. At the same time, regulatory measures

need to be taken to keep history from repeating itself in the form of another government

bailout. Americans deserve to believe in the American Dream, and it is time to take steps

to make that happen.

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TABLE OF CONTENTS

INTRODUCTION 3

THE PAST 3

THE FEDERAL RESERVE 3

THE MEANING OF YIELD CURVES 5

JAPAN’S TWENTY YEAR STRUGGLE 6

THE RISE AND FALL OF BUBBLES 7

THE DOT-COM BUBBLE 9

THE SUBPRIME MORTGAGE CRISIS 11

RECOMMENDATIONS 15

TREAT THE SICKNESS, NOT THE SYMPTOMS 15

THOSE WHO CANNOT LEARN FROM HISTORY ARE DOOMED TO REPEAT IT 18

CONCLUDING REMARKS 19

APPENDIX 20

WORKS CITED 26

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Introduction

America is still licking its wounds that came from the subprime mortgage crisis

while wondering how seemingly rational people could have behaved so irrationally that

they almost destroyed the entire United States financial system. The markets have

bounced back to pre-crisis levels, but the low interest rates required to bounce back so

quickly still remain and are beginning to seem risky as Japan struggles to keep its

economy afloat. There is a way out of this problem and if any nation can forge through a

tough issue it is the United States. It will require an in-depth understanding of past

financial crises and significant group effort from the Federal Reserve and the rest of

federal government, but the ends will justify the means. Change is necessary to keep

history from repeating itself, and there is no better time for change than in the wake of

disaster.

The Past

The Federal Reserve

The Federal Reserve System (“The Fed”) was created in 1913 following the Panic

of 1907 after congress passed the Federal Reserve Act. The Panic of 1907 was a stock

market crash that followed a failed attempt to corner the copper market and the

subsequent collapse of Knickerbocker Trust. Knickerbocker was the third largest trust at

the time and caused a run on the banks. Even though J.P. Morgan and several other

wealthy businessmen attempted to prop up the market as they had done successfully in

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1893, the lack of U.S. Treasury reserves coupled with continued public fear were too

much to overcome.

Initially, the Federal Reserve was created as a lender of last resort in order to

remove this burden from wealthy individuals. It was also given the power to control all

monetary policy in the United States through the use of several different tools. The Fed

has the power to set the Federal Funds Rate, the overnight rate at which member banks

lend excess reserves to each other. While the Federal Funds Rate is an effective tool, the

Fed is cautious to change it so their main tools are open market operations, the discount

rate and reserve requirements. Open market operations refers to the buying or selling of

government securities in the open bond market while the discount rate and reserve

requirements are policy changes. The discount rate is the rate at which member banks

borrow from the Federal Reserve and reserve requirements determine the amount of

capital a member institution must keep in reserve.

Each of these tools is used to control monetary policy. More specifically, the

Federal Reserve Act states that the goal of Fed monetary policy is to “maintain long run

growth of the monetary and credit aggregates commensurate with the economy's long run

potential to increase production, so as to promote effectively the goals of maximum

employment, stable prices, and moderate long-term interest rates.”1 The description

clarifies the goal of the Federal Reserve by laying out specific metrics of unemployment,

inflation and long-term rates as measures of successful policymaking.

1 Federal Reserve Act of 1913

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The Meaning of Yield Curves

The Federal Reserve is able to use monetary policy to control both short-term and

long-term Treasury Yield rates. Changing the Federal Funds Rate and Discount Rate,

which is set by the Federal Reserve, controls short-term rates. Long-term rates, on the

other hand, are more difficult to control and require open market bond sales or purchases

by the Fed. To understand this process it is necessary to understand how the United States

Treasury market works.

When the government issues a bond they do so with a stated “coupon”. This

coupon determines the semi-annual payment that the bondholder receives and has a face

value of $1000. When a bond is traded at “100” it is said to be trading “at par value” and

requires an initial investment of $1000. However, in the open market this is usually not

the case. Instead, the market decides how much they are willing to pay for a given

coupon, which determines the actual market yield. If a bond is trading below 100, or

below par, the actual yield is higher than the states coupon since the initial price is

discounted. On the other hand, a bond trading above 100 is said to be trading at a

premium and the actual yield the purchaser receives is lower than the stated coupon. In

other words, bond price and bond yield are inversely related and, as with all securities,

the price is determined through open market supply and demand. Through quantitative

easing programs, the Fed can control long-term yields by increasing demand and,

therefore, price. Between 2008 and October 2014, the Fed accumulated $4.5 trillion in

assets including treasury notes and mortgage-backed securities.

The most important chart to understand in the bond market is called a yield curve.

A yield curve plots bond maturities on the x-axis and yields on the y-axis. For US

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Treasuries, this curve has maturities ranging from 1 month to 30 years (Figure 1). During

normal economic times, the treasury curve will have a positive slope. However, during

unusual times in the market, long-term yields can decrease to below short-term and create

an inverted yield curve. Since 1970, an inverted yield curve has preceded each of the

seven recessions in the United States. The theory behind using the slope of the yield

curve as an indicator of a future recession is that people are willing to accept a lower

yield to reduce exposure to near-term economic slowdown or decline.

Japan’s Twenty Year Struggle

Following a recession in the early 1990s, the Bank of Japan announced on

February 2, 1999 that it would be adopting a zero interest rate policy. Aside from a brief

period in 2000 to 2001, it maintained this policy along with implementing quantitative

easing measures until 2006. After the subprime mortgage crisis, they again began

quantitative easing and have continued to expand the bond-buying program since then.

While these programs have allowed Japan to avoid a depression, they have experienced

five recessions since the first announcement of a zero interest rate policy (Figure 2).

Prior to the recession in the early 1990s, Japan saw a negative difference between

their 10-year and short-term interest rates, indicating an inverted yield curve. However, in

the five recessions since there has continued to be a positive spread between these two

interest rates. Instead of allowing the economy to recover more quickly, low interest rates

have kept Japan’s annual GDP growth below 2% and caused them to lose a valuable

recession indicator (Figure 3). The Bank of Japan’s experience with low rates is a perfect

example of how easy it is to implement low rates and how difficult it can be to return to

normal rate policies. Simon Grose-Hodge, the head of investment strategy for LGT

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Group, says, “They simply can’t afford any meaningful increase in interest rates…the

Japan experience suggests very low rates are going to be around for a long time”2. Grose-

Hodge realizes that as the Bank of Japan has become encumbered with growing debt

levels, it becomes increasingly difficult to raise rates without risking an economic

downturn. Therefore, Japan has been forced to continue their low rate policies even as

they continue to see lagging results.

The Rise and Fall of Bubbles

Historically there are four main “legs” of an asset bubble: low rates, leverage,

laissez-faire government policies, and public participation. It is easiest to think of these

legs as holding up the bubble as they would a table. As long as they continue to exist and

increase, the bubble is sustained and continues to grow. However, once a single leg

begins to shake it is only a matter of time before the bubble bursts, just as a table would

collapse.

All of these legs are a result of different aspects of government policy. As

discussed earlier, the Federal Reserve controls interest rates through monetary policy

decisions. Low rates are typically the first leg of the bubble since they generally appear

following a recession as a means of economic stimulus and can quickly lead to the

appearance of the other three legs. Laissez-faire government consists of deregulation of

either the entire financial market or a specific industry where the government neglects to

require sufficient oversight. This can occur for a number of reasons, including lobbying

efforts by corporations or new and unregulated products. The next leg of a bubble is

increased financial leverage. Leverage consists of companies or individuals carrying

2 Pesek, William. "Japans's Scary Lesson on Slashing Interest Rates."Bloomberg.com. Bloomberg, 25 Apr. 2013. Web. 04 May 2015.

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higher than normal levels of debt that allow them to realize high returns as a result of

increased risk in strong financial times. Leverage is a result of the prior rise of the first

two legs since low rates encourage increased borrowing and government must fail to

implement capital requirements as borrowing increases. The final leg of a bubble is

public participation. The unsophisticated public investor is always the last one to the

party and provides to final push to create a bubble. When unsophisticated investors

beginning suddenly investing it creates momentum that irrationally drives the market

higher. Joe Kennedy famously took advantage of this fact when he exited the stock

market before the Crash of 1929 after receiving a stock tip from a shoeshine boy.3 This is

an example of public participation from before the Great Depression, but it is far from

typical. Generally, this leg can be measured by mutual fund participation statistics since

they are the most accessible investment vehicles for the general public (Figure 4).

These four legs are the cause of an asset class increasing in value enough to create

a bubble, but if they do not falter the bubble will not burst. Historically, public

participation, the last leg, eventually causes one of the other legs to start “shaking”. In the

time leading up to and immediately following Black Monday in 1929 all three of these

legs collapsed. First, the Fed raised the Federal Funds Rate three times in 1928, causing

low rates to quickly disappear. Then, initial margin requirements were reduced from 90%

to 50%; meaning margin investors could now borrow only half of the cost of their

investment instead of 90%, resulting in suddenly reduced leverage. Finally, following the

stock market crash, the government passed the Smoot-Hawley Tariff Act and ended a

period of laissez-faire government with a 50% increase in import duties.

3 Rothchild, John. "Fortune." When the Shoeshine Boys Talk It Was A Great Sell Signal In 1929. So What Are The Shoeshine Boys Talking About Now?Fortune, 15 Apr. 1996. Web. 06 May 2015.

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The Dot-Com Bubble

On March 10, 2000 the Nasdaq Composite Index, a market index for the Nasdaq

exchange that hosts mostly technology companies, closed at an all-time high of 5,048.62,

which represented a five-year annual growth rate of almost 45%. Exactly 31 months later,

the Nasdaq hit a low of 1,108.49 following the burst of the Dot-Com Bubble. This bubble

had all of the telltale signs of previous bubbles and yet very few paid any attention, even

going so far as to ignore Fed Chairman Alan Greenspan’s warned, “Irrational exuberance

has unduly escalated asset values”4.

All four legs of an asset bubble were present in the years leading up to the boom

and bust of the Dot-Com bubble. This time, however, the easy money was not a direct

result of extremely low interest rates, although the 10-Year Treasury had been in steady

decline since 1982. Instead, technology and Internet companies were receiving large

venture capital investments and Initial Public Offerings (IPOs) were frequent and wildly

successful (Figure 5). In 1999 alone there were 457 IPOs in the United States made up of

mostly Nasdaq companies, 117 of which saw their value double in the first day of

trading.5 While margin investors in the 1920s were gaining leverage through margin

accounts where they borrowed a large portion of the capital needed to buy stock, tech

companies in the Dot-Com boom leveraged their only asset: people. Many of the

companies that went public in 1999 had little to no earnings and they could not secure

debt financing since in many cases their most valuable asset was the office computers.

So, while they did not leverage their balance sheets in a traditional sense, they secured

4 Greenspan, Alan. "Remarks by Chairman Alan Greenspan." The Annual Dinner and Francis Boyer Lecture of The American Enterprise Institute for Public Policy Research. Washington, D.C. 5 Dec. 1996. The Federal Reserve Board. Web. 5 May 2015.5 Colombo, Jesse. "The Dot-com Bubble." The Bubble Bubble. N.p., n.d. Web. 05 May 2015.

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equity financing at never before seen multiples, causing the Nasdaq Composite price-to-

earnings ratio to reach above 100x forward earnings (Figure 6).6 In the late 1990s the

laissez-faire government leg appeared when congress passed the Taxpayer Relief Act of

1997. The Taxpayer Relief Act introduced several tax reduction measures including a

lower capital gains tax, the creation of Roth IRAs, and various exemptions for personal

residence sales, estate taxes, family farms and small businesses.7 The reduction in capital

gains taxes provided by the Taxpayer Relief Act encouraged individuals to invest in the

stock market and provided the last leg needed to build the Dot-Com bubble. This

additional incentive was all the public needed to begin taking part in technology and

Internet IPOs, resulting in the unrealistic valuations of 1999.

The Dot-Com bubble did not burst from a single event, instead it was a collection

of catalysts that caused the initial crisis and slow recovery that followed. Following the

market peak in early 2000, the federal funds effective rate reached 6.5% and the United

States experienced an inverted yield curve (Figure 7). Furthermore, Barron’s published

an article just ten days after the market peaked and predicted turmoil in the following 12

months. The article cited a study of 207 Internet companies conducted by Pegasus

Research International, an Internet stock evaluation firm, that stated 74% of the surveyed

companies had negative cash flows and predicted nearly a quarter of them would run out

of cash in the coming year. Some other warning signs included were the combined $1.3

trillion valuation of Internet companies, numerous insider selling disclosures and a

rebound in the Dow Jones after a drop-off in the Nasdaq, signifying a change in investor

6 Ro, Sam. "This Definitive Chart Destroys The Argument That We're Reliving The Bubble Of The Late 1990s." Business Insider. Business Insider, Inc, 09 Aug. 2014. Web. 05 May 2015. 7 Taxpayer Relief Act of 1997

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sentiment with regard Nasdaq stocks.8 As investors became more rational and realized

these risks, the bubble finally burst, causing the Nasdaq Composite to lose more than half

of its value in 12 months.

The Subprime Mortgage Crisis

The most recent financial crisis began in August 2007 following the collapse of

the United States housing and subprime mortgage market. The effects of this crisis

continue to linger in the United States economy even though the recession is technically

over. While this most recent crisis was more detrimental to the financial system than the

Dot-Com bubble, it can once again be understood using the four legs of asset bubbles.

Similarly to the Great Depression, the subprime mortgage crisis was most

detrimental to the American dream and the average American. As always it began with

easy money as a result of low interest rates. 10-Year Treasury rates fell below 6% in the

mid-2000s for the first time since the 1960s and consumers were more than willing to

borrow to take advantage of potential opportunity. Middle-class Americans began to

purchase new homes with easily accessible loans from mortgage lenders across the

country. However, as rates continued to remain low and lenders continue approving

mortgages, they began to run out of acceptable borrowers. Instead of maintaining strict

standards, banks started to make riskier loans to put excess capital to work even when

they knew their creditors would likely default on the loan if interest rates rose, a practice

known as subprime lending. Financial institutions and consumers alike began to take on

excess debt; banks leveraged their balance sheets while average Americans bought a

larger or second home as the banks cheered on the American dream of home ownership.

8 Willoughby, Jack. "Burning Up." Barron's. Barron's, 20 Mar. 2000. Web. 05 May 2015.

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All of this was possible because of deregulation that came from 1999 in the form of the

Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act repealed the Glass-Steagall Act

of 1933, thereby removing restrictions on universal banks and allowing investment

banks, commercial banks and insurance companies to operate as a single entity. Glass-

Steagall was enacted after the Great Depression and carried the United States economy

through more than 50 years of prosperity. However, by 1999 many people thought the

bill should be repealed including Treasury Secretary Larry Summers who said it would

benefit the economy “by promoting financial innovation, lower capital costs and greater

international competitiveness”.9 Eventually Sandy Weill, the Chairman of Travelers

Group lobbied congress to repeal the bill so he could acquire Citicorp, a commercial

bank, and form Citigroup.10 Citigroup became the first universal bank since before the

Great Depression. This merger led to several other megamergers including JP Morgan

and Chase Manhattan. More importantly, joining these two businesses together gave a

bank the ability to issue loans using federally-insured customer deposits, which Glass-

Steagall prohibited, and subsequently securitized that loan debt into complex financial

products called collateralized debt obligation (CDOs).11 This new breed of structured

financial product allowed banks make to profit on both ends of a mortgage loan while

subsequently hedging their risk through purchasing Credit Default Swaps (CDSs),

essentially a CDO insurance policy, from insurance companies like AIG. Their balance

sheets appear less risky through holding CDSs even though banks like Lehmann Brothers

9 Schroeder, Michael. "Glass-Steagall Accord Reached After Last-Minute Deal Making." WSJ. Wall Street Journal, 25 Oct. 1999. Web. 06 May 2015.10 Schroeder, Michael11 Brodwin, David. "Glass-Steagall Critics Get a Little Bit Right and the Rest All Wrong." US News. U.S.News & World Report, 23 Aug. 2013. Web. 06 May 2015.

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had leverage ratios as high as 44:1 debt-to-equity.12 The public was involved in every step

of the housing bubble up until this point, but when pension plans and other seemingly

low-risk funds started buying CDOs that were rated as AAA debt instruments, the entire

wealth of the American public became entrenched in the risky behavior of large banks.

Subprime lenders continued making more and more loans as the demand for CDOs

continued to increase until, eventually, years of excess on Wall Street drove the entire

financial system to the brink of collapse.

The Case Shiller Home Price Index hit a high in 2006 following several years of

subprime lending (Figure 8). Shortly thereafter, the treasury yield curve became inverted

for the first time since before the Dot-Com bubble (Figure 9). When it began to fall many

subprime borrowers, who had put minimal cash down on their homes, found that they

owed more on their mortgage than their home was worth. Logic began to prevail and

many of these creditors defaulted on their debt, resulting in further declines in United

States home prices. As this trend gained momentum, banks quickly realized that they

were overleveraged and inadequately hedged. The first major market shock occurred in

March 2008 when Bear Stearns was no longer able to honor its debts and was acquired by

JP Morgan in an emergency sale. Even though the housing market continued to decline,

the large banks managed to stay afloat through the summer. This all changed in

September when Lehman Brothers, which reached a peak leverage of 44:1 and highly

exposed to the subprime mortgage market, faced a liquidity crunch.13 Lehman, however,

did not receive the same emergency aid that Bear had and eventually declared Chapter 11

bankruptcy. Lehman’s demise caused a panic in the markets and soon nearly every large

12 Crossley-Holland, Dominic. "Lehman Brothers, the Bank That Bust the Boom." The Telegraph. Telegraph Media Group, 6 Sept. 2009. Web. 06 May 2015.13 Crossley-Holland, Dominic

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financial institution was faced with a lack of liquidity. In the face of this crisis, congress

passed Emergency Economic Stabilization Act of 2008, which gave the Secretary of the

Treasury $700 billion to help banks liquidate troubled assets and put measures in place to

help victims of predatory lending restructure their mortgages so they could keep their

home.14

The Emergency Economic Stabilization Act was the only the second bailout in

United States history and the first time the Federal Reserve adopted a zero interest rate

policy. Since 2008 the economy has recovered from the recession but there are still

lasting effects. The Fed has continued to keep rates at near-zero levels and while

unemployment has returned to normal levels, the percentage of the total population

employed is still well below 2008 levels. This is more meaningful to the state of our

economy because it means that more people have either given up on looking for work or

are working under the table. We did not see this during the aftermath of the Dot-Com

bubble because the people affected most were wealthy investors who did not change their

consumption habits since they remained wealthy even after the bubble burst. However,

following the subprime mortgage crisis average Americans lost their homes, which

represented more than 60% of the net worth of middle-quintile Americans (Figure 10).

This resulted in an extreme decrease in net worth for low and middle-income Americans,

a much larger group than the tech investors (Figure 11). After this loss of wealth many

Americans were forced to curb their consumption habits, thereby slowing the economy as

a whole.15 The important difference in this all too familiar of a bubble is the parties

involved; it is an example of sophisticated Wall Street investors taking advantage of a

14 Emergency Economic Stabilization Act of 200815 Sufi, Amir, and Atif Mian. "Why the Housing Bubble Tanked the Economy And the Tech Bubble Didn't." FiveThirtyEightEconomics. N.p., 12 May 2014. Web. 06 May 2015.

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favorable economic environment by exploiting unsophisticated investors and coming out

on top even after near-disaster. Effects of this bubble will be observable for a long time

because of the structural changes it caused in the United States economy.

Recommendations

Since the Federal Reserve Act went into effect the United States has gone through

numerous boom and bust cycles including the Great Depression, which remains the

period with the highest rate of unemployment in United States history.16 Yet even after

another market crash in 2008, nearly a century after the Fed’s inception, they continue to

promote the same goals. Only in hindsight it is possible to identify the same root causes

of every market bubble, with the only differences being who won, who lost, and which

asset was overinflated. The United States government needs to rethink their strategy

towards fiscal and monetary policy in order to avoid future sudden market events.

Treat the sickness, not the symptoms

The stated goal of the Federal Reserve is “to promote effectively the goals of

maximum employment, stable prices, and moderate long-term interest rates”17. However,

since the subprime mortgage crisis in 2007 the Fed has failed to achieve those goals.

According to the most recent statistics, unemployment is currently 5.5%18, trailing 12

month inflation is -0.1%19 and the 10-Year Treasury yield is 2.24%20. While the

16 "U.S. Bureau of Labor Statistics." U.S. Bureau of Labor Statistics. United States Department of Labor, n.d. Web. 06 May 2015.17 Federal Reserve Act of 191318 "Employment Situation Summary." U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, 3 Apr. 2015. Web. 06 May 2015.19 "Consumer Price Index Summary." U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics, 17 Apr. 2015. Web. 06 May 2015.20 "U.S. 10 Year Treasury Note." WSJ.com. Dow Jones & Company, 06 May 2015. Web. 06 May 2015.

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unemployment rate is in line with the median rate of unemployment, the employment

population ratio is still near the lowest level since before 1985.21 Furthermore, the Fed

recently reported that its target inflation rate is 2%22 yet over the last 12 months we have

experienced slight deflation while maintaining a 10-year rate that is 155 basis points

below the historical median.23

Even though the recession ended more than five years ago, the Federal Reserve

has maintained a policy of keeping short-term interest rates near zero. The role of the

Federal Reserve is, as Chairman William Martin Jr. once said, “to take away the punch

bowl just as the party gets going”. The problem now is that the party clearly started a

long time ago and now we have surpassed the inflation-adjusted all-time high of the S&P

500. However, in order to get there the Fed had to sacrifice its most valuable tool of

monetary policy: the power to set short-term interest rates. Unfortunately, the solution is

not as simple as raising the short-term interest rate and weathering a brief economic

downturn. Ben Bernanke recently released an article that explained raising interest rates

too soon will move us too far from the equilibrium interest rate, which is currently very

low. If the Fed moves rates too high the economy will eventually slow and lead into

another recession and if rates are kept too low the economy will “overheat” and we will

experience excessive inflation.24 In other words, we have forced ourselves into a situation

similar the one Japan has faced since adopting a zero interest rate policy for the first time

in the 1990s. If we do not remedy the situation we will also go through recessions with

21 U.S. Bureau of Labor Statistics22 "Why Are Interest Rates Being Kept at a Low Level?" Board of Governors of the Federal Reserve System. Federal Reserve, 8 Apr. 2015. Web. 06 May 2015.23 U.S. Bureau of Labor Statistics24 Bernanke, Ben S. "Why Are Interest Rates so Low?" Ben Bernanke's Blog. The Brookings Institution, 30 Mar. 2015. Web. 06 May 2015.

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near-zero short-term rates just as Japan has in the last two decades. Not only will we go

into these recessions without the ability to stimulate growth with low rates, there will also

be no warning this time as there has been in the past. If the short end of the yield curve is

kept near zero it will be impossible for the curve to invert and we will have lost the single

best recession predictor we have. The problem of stagnant low interest rates is one that

needs to be solved as quickly as possible in order to maintain economic stability in the

United States.

Stagnant low interest rates are merely a symptom of a larger problem with Fed

policy. Since the subprime mortgage crisis, the Fed has relied entirely on monetary policy

to solve our economic problems. While the economy has grown as a whole, real income

growth only recently crossed into positive territory and we are now facing increasing

wealth inequality. In order to solve this problem the Federal Reserve needs to change

their goals. Rather than striving for maximum employment, the Fed should be striving for

better employment for the portion of the population who has left the labor force. Charlie

Munger, the Vice President of Berkshire Hathaway, recently said, "I'm deeply suspicious

about printing money and throwing it around instead of printing money and building

infrastructure and so on."25 Munger is right in being suspicious of the Fed strategy of

throwing money around. Quantitative easing and low rates clearly helped to pull the

United States out of the recession but it is time to begin spending money on creating jobs

through public works projects rather than creating policies to pump up financial assets

that mostly benefit the wealthy. The Federal Reserve will need congress to work

alongside them in approving infrastructure projects while simultaneously using their

25 "Bill Gates: Low Rates Pose Leverage, Bubble Risks." Yahoo! Finance. Yahoo!, 4 May 2015. Web. 06 May 2015.

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ability to control monetary policy to make new ventures profitable. The last five years

have proven that low rates can pull the financial markets out of a recession, but in order

to achieve long-term growth and prosperity we need to shift our attention to creating

American jobs and real wage growth.

Those Who Cannot Learn From History Are Doomed To Repeat It

The Great Depression, the Dot-Com bubble and the subprime mortgage crisis are

just three of many examples of asset bubbles where four clear legs can be identified. Each

time a market crash has occurred the government has formed an investigative committee,

determined a cause, and passed legislation to remedy the problem. However, we continue

to have market crashes even though new regulations are supposed to prevent them from

occurring. Rather than waiting for another crash to occur before passing legislation, it is

time to implement preventative measures to keep irrational exuberance at bay.

Following the Great Depression formed a commission led by Ferdinand Pecora to

find the cause of the 1929 market crash. At the end of the investigation, congress passed

three bills, one of which was Glass-Steagall, which significantly increased government

oversight of the financial industry. The passing of these three acts marked the beginning

of a period of more than 50 years where there were no major market crashes. Even after a

long proven track record of success, Sandy Weill was able to have this bill repealed,

paving the way for universal banks and the eventual subprime mortgage crisis. Following

the subprime mortgage crisis the government passed Dodd-Frank, which again created

oversight and added a provision for liquidating “too-big-to-fail” banks, but the universal

banks still remain today. The continuing existence of universal banks means that they can

still use federally insured customer deposits for speculation. The only way to remedy this

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is to reinstate Glass-Steagall and break up the banks once again into more easily managed

and regulated entities. The combination of the Dodd-Frank’s modernized regulations and

Glass-Steagall’s time-proven effectiveness will allow the financial system to operate with

less risk and hopefully lead the United States to another half century without a financial

crisis.

Concluding Remarks

Show me someone who says the can predict the next asset bubble with absolute

certainty and I will show you a liar. The very nature of a bubble is that they are not

predictable and before investors have time to identify and plan a graceful return to

rationality it is already too late. However, there are steps that the Federal Reserve and

regulatory agencies can take in order to prevent a bubble-friendly environment from

growing. Doing so will require sweeping changes in thought regarding regulatory

strategy and cause some short-term pain, but in the long-run we will all be better off. It is

time for the Federal Reserve to modernize its goals to conform to today’s economic

environment and work together with congress to implement legislation that allows for

more strategic monetary policy.

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Appendix

Figure 1: Treasury Yield Curve on May 6, 2015

Source: www.treasury.gov

Figure 2: Japanese interest rates and recessions

Source: www.etfguide.com

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Figure 3: Japan GDP Growth Rate

Source: www.tradingeconomics.com

Figure 4: Total number of US Mutual Funds

Source: web.stanford.edu

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Figure 5: IPO Proceeds 1980-2009

Figure 6: Price to Earnings Ratio of Nasdaq and S&P 500

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Figure 7: Treasury Yield Curve as of April 3, 2000

Source: www.treasury.gov

Figure 8: Case Shiller Home Price Index in March 2015 dollars

Source: www.multpl.com

23

Figure 9: Treasury Yield Curve as of November 1, 2006

Source: www.treasury.gov

Figure 10: Home burden by net-worth quintile

Source: FiveThirtyEightEconomics

24

Figure 11: Effect of subprime mortgage crisis on richest and poorest Americans

Source: FiveThirtyEightEconomics

25

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