The former head of the FDIC thinks we're in the middle of a "bond bubble."
As head of the Federal Deposit Insurance Corporation during the financial crisis, Sheila Bair -- a lifelong Republican -- became a hero to bailout skeptics, and liberals in particular, for her stance against the soft treatment of big banks and in favor of aiding suffering homeowners. She's cemented that reputation since leaving government, advocating ideas like breaking up too-big-too-fail firms and taxing financial transactions, and publishing a book full of criticisms about how the government reacted to Wall Street's meltdown.
So Bair probably isn't going to lose her status as a left-wing -- or at least anti-banker -- icon any time soon (she even endorsed Elizabeth Warren). But lately she's been on the warpath about another issue, one she returned to in a discussion at the Washington Ideas Forum today. She thinks we're in the midst of a bond bubble that could lead us towards another big bust, or perhaps a new financial crisis, and that the Fed needs to pop it by allowing interest rates to rise.
Even if you love her positions on banks and housing, this one should give you some pause.
Bair's comments about bonds and interest rates were fairly brief today, so here's a more fleshed out version of her argument from a Fortune column she wrote back in April:
The Fed has maintained interest rates at or near zero for four years running, even though the financial system has been relatively stable since 2009. The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in. Sooner or later, the bond bubble will burst. History has shown that a structurally weak economy combined with a fiscally irresponsible government propped up by accommodative central-bank lending always ends badly. Absent a change in policies, a toxic brew of volatile interest rates and uncontrollable inflation could define our future.
As we saw in the years leading up to the subprime crisis, yield-hungry investors are taking on more and more risk. Pension managers are investing in hedge funds, and gullible investors are buying up junk bonds. Meanwhile, low-yielding assets pile up on the balance sheets of more risk-averse banks. If interest rates suddenly spike, bankers may find that the paltry returns on their loans are insufficient to cover interest on their deposits.
Bair has a fair point about junk bonds, which you can think of essentially as sub-prime corporate debt. There are signs that the Fed's low interest rates are pushing investors to pour unsafe amounts of money into these bets. But her fretting about Treasury bonds is far off base. Fundamentally, Treasury yields are staying low because growth and inflation are so low. And besides, for all our deficit problems, American debt is still considered a safe haven in a scary financial world -- the full faith and credit of the United States stands for something in the globe's eyes. There just aren't that many other assets around today that central banks and investors think are sound enough to be considered essentially cash. That won't change until the rest of the world economy gets itself in order, at which point the rest of the U.S. may be healthy enough to start talking about raising rates without sending ourselves back into a recession.
And for what it's worth, as The Atlantic's Matt O'Brien will tell you, there's really no danger that we'll be experiencing "uncontrollable inflation" any time soon.
Bair waves off the concern that higher interest rates could knock the economy off its fragile recovery. She's more worried that easy money is letting Congress duck its responsibility to get spending and government debt under control. Yet Washington is in the middle of a massive showdown over the fiscal cliff, in which the only question isn't whether we need to reduce the deficit, but also how to do it. She may or may not be right about banks, but on hard money she's very much in the wrong.
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