Lehman Brothers: Looking Five Years Back and Ten Years Ahead
Remarks by Thomas M. Hoenig, Vice Chairman,
Federal Deposit Insurance Corporation
Presented to the
National Association of Corporate Directors,
Texas Tri-Cities Chapter Conference,
Houston, Texas
September 2013
Introduction
A fundamental principle in economics is that incentives matter. If the rules of the game
provide advantages to some over others, protect players against the fallout of taking on
excessive risk, or enable irresponsible behavior, we can be confident that the choices
people make will be imprudent and the results of the misaligned incentives will be bad.
In the US financial system these conditions were in force during the decade leading to
the Great Recession. It was a decade when monetary policy was highly
accommodative; when government protections and subsidies were extended to ever
more financial activities; when market discipline became a buzz word rather than a tool;
and when the competitive advantage bestowed on some sectors of the industry led to a
less competitive market.
More concerning is that five years after the crisis, despite new laws and regulations, we
are replicating many of the conditions that contributed to the crisis, but we somehow are
expecting things to end differently. How so?
This morning, I will discuss the parallels between this earlier period and now, and I will
make a case for a bolder set of actions to address weaknesses in a system that
continues to impede our financial markets and economy.
Setting the Stage: Low Interest Rates
Extended periods of exceptionally low interest rates undermine a sound
economy. Their short-term effects on the economy can be favorable and dramatic,
which creates a significant temptation for policymakers to keep rates low for a
considerable period. However, history suggests that extended periods of abnormally
low rates often lead to negative long-run effects as they weaken credit standards,
encourage the heavy use of credit, and too often adversely affect financial and
economic stability.
For example, starting with the Mexican financial crisis of 1994 through the Asian and
Russian crises of the late ’90s, aggressive expansionary US monetary policy was used
with apparent success. In each instance, the immediate crisis was staunched, markets
continued operating, and the economy bounced back. Such success led to the
expectation that monetary policy could clean up the effects of any financial excess or
imbalance that the US economy might develop. Low interest rates became the
Remarks by Thomas M. Hoenig, Vice Chairman,
Federal Deposit Insurance Corporation
Presented to the
National Association of Corporate Directors,
Texas Tri-Cities Chapter Conference,
Houston, Texas
September 2013
Introduction
A fundamental principle in economics is that incentives matter. If the rules of the game
provide advantages to some over others, protect players against the fallout of taking on
excessive risk, or enable irresponsible behavior, we can be confident that the choices
people make will be imprudent and the results of the misaligned incentives will be bad.
In the US financial system these conditions were in force during the decade leading to
the Great Recession. It was a decade when monetary policy was highly
accommodative; when government protections and subsidies were extended to ever
more financial activities; when market discipline became a buzz word rather than a tool;
and when the competitive advantage bestowed on some sectors of the industry led to a
less competitive market.
More concerning is that five years after the crisis, despite new laws and regulations, we
are replicating many of the conditions that contributed to the crisis, but we somehow are
expecting things to end differently. How so?
This morning, I will discuss the parallels between this earlier period and now, and I will
make a case for a bolder set of actions to address weaknesses in a system that
continues to impede our financial markets and economy.
Setting the Stage: Low Interest Rates
Extended periods of exceptionally low interest rates undermine a sound
economy. Their short-term effects on the economy can be favorable and dramatic,
which creates a significant temptation for policymakers to keep rates low for a
considerable period. However, history suggests that extended periods of abnormally
low rates often lead to negative long-run effects as they weaken credit standards,
encourage the heavy use of credit, and too often adversely affect financial and
economic stability.
For example, starting with the Mexican financial crisis of 1994 through the Asian and
Russian crises of the late ’90s, aggressive expansionary US monetary policy was used
with apparent success. In each instance, the immediate crisis was staunched, markets
continued operating, and the economy bounced back. Such success led to the
expectation that monetary policy could clean up the effects of any financial excess or
imbalance that the US economy might develop. Low interest rates became the
expected remedy that would stimulate the economy and avoid recession, or that would
prevent the proliferation of a crisis.
Having been successful during the ’90s, the Federal Open Market Committee (FOMC),
"doubled down" its use of low interest rates during the subsequent decade as it
encountered financial and economic weaknesses. Following the collapse of the tech
bubble, the real federal funds rate was negative for most of the period 2002 through
2005. It is noteworthy that in June 2003, the nominal federal funds rate was lowered
from 1 1/4 percent to 1 percent and remained there for nearly a year, despite the fact
that the economy grew at a rate of nearly 7 percent in the quarter following this rate
reduction.
Because there were no signs of accelerating inflation, the FOMC felt confident that
there was no need to quickly reverse policy, so it remained either highly or relatively
accommodative well into the recovery. The first increase in the federal funds rate
occurred in June 2004, only after evidence was overwhelming that economic activity
had begun to accelerate. Not until March 2006 did the federal funds rate reach its long-
term average level.
Within an environment of a highly accommodative monetary policy and sustained low
interest rates, credit growth accelerated and serious financial imbalances developed.
During the period 2002 to the end of 2007, total debt outstanding for households and
financial and non-financial firms increased from $22 trillion to $37 trillion, or almost 70
percent. In hindsight, of course, it seems obvious that problems would result.
This history begs the question, therefore, of how current monetary policy might affect
economic and financial conditions in 2013 and beyond. The FOMC again is fully
engaged in conducting a highly accommodative monetary policy. The target federal
funds rate is currently zero to 25 basis points. Through the Federal Reserve’s
Quantitative Easing policy, its balance sheet and bank reserves have ballooned to
nearly four times the size they were in January 2008. As a result, the real federal funds
rate has been negative for most of the period from 2008 to the present.
As with the earlier period, inflation in the US remains relatively subdued, facilitating
continued low rates. However, the US also is experiencing significant price increases in
various assets, including, for example, land, stocks, and bonds. Banks and the entire
financial sector are exposed, directly and indirectly, to significant negative price shocks
in nearly all interest rate-sensitive sectors. Also, as capital desperately seeks out yield,
there have been significant US dollar capital flows across the globe, causing what
appears to be increased financial vulnerability, uncertainty, and instability.
Thus, the actions the FOMC has taken since the crisis ended are more aggressive and
will be in place far longer than those taken in the early part of the last decade.
Those who support current money policy insist that circumstances are different this time
- a phrase itself that should cause alarm. They suggest that policymakers have better
tools to deal with imbalances in the form of renewed market discipline and macro-
prevent the proliferation of a crisis.
Having been successful during the ’90s, the Federal Open Market Committee (FOMC),
"doubled down" its use of low interest rates during the subsequent decade as it
encountered financial and economic weaknesses. Following the collapse of the tech
bubble, the real federal funds rate was negative for most of the period 2002 through
2005. It is noteworthy that in June 2003, the nominal federal funds rate was lowered
from 1 1/4 percent to 1 percent and remained there for nearly a year, despite the fact
that the economy grew at a rate of nearly 7 percent in the quarter following this rate
reduction.
Because there were no signs of accelerating inflation, the FOMC felt confident that
there was no need to quickly reverse policy, so it remained either highly or relatively
accommodative well into the recovery. The first increase in the federal funds rate
occurred in June 2004, only after evidence was overwhelming that economic activity
had begun to accelerate. Not until March 2006 did the federal funds rate reach its long-
term average level.
Within an environment of a highly accommodative monetary policy and sustained low
interest rates, credit growth accelerated and serious financial imbalances developed.
During the period 2002 to the end of 2007, total debt outstanding for households and
financial and non-financial firms increased from $22 trillion to $37 trillion, or almost 70
percent. In hindsight, of course, it seems obvious that problems would result.
This history begs the question, therefore, of how current monetary policy might affect
economic and financial conditions in 2013 and beyond. The FOMC again is fully
engaged in conducting a highly accommodative monetary policy. The target federal
funds rate is currently zero to 25 basis points. Through the Federal Reserve’s
Quantitative Easing policy, its balance sheet and bank reserves have ballooned to
nearly four times the size they were in January 2008. As a result, the real federal funds
rate has been negative for most of the period from 2008 to the present.
As with the earlier period, inflation in the US remains relatively subdued, facilitating
continued low rates. However, the US also is experiencing significant price increases in
various assets, including, for example, land, stocks, and bonds. Banks and the entire
financial sector are exposed, directly and indirectly, to significant negative price shocks
in nearly all interest rate-sensitive sectors. Also, as capital desperately seeks out yield,
there have been significant US dollar capital flows across the globe, causing what
appears to be increased financial vulnerability, uncertainty, and instability.
Thus, the actions the FOMC has taken since the crisis ended are more aggressive and
will be in place far longer than those taken in the early part of the last decade.
Those who support current money policy insist that circumstances are different this time
- a phrase itself that should cause alarm. They suggest that policymakers have better
tools to deal with imbalances in the form of renewed market discipline and macro-