Yellen is from Mars, Congress is from Venus

Source: Life's Adventures

In her semiannual testimony to Congress, Chair Yellen spent quite a bit of time discussing financial stability, the Orange is the New Black of financial circles. It's the summer blockbuster that everybody's talking about, and the conversation carries enormous consequences for financial markets.

Financial Stability is the New Black

Financial stability is in vogue for 3 reasons. First, we're all getting worried about bubbles. Second, volatility is eerily low, so we're looking for threats on the horizon. Third, some influential economists (including FOMC Vice Chair Stanley Fischer) have suggested that Congress add financial stability to the Fed's mandate, alongside maximum employment and price stability.

Source: Yahoo Finance

Concerns about financial instability are widespread. Nightmares of the "Greenspan put" and "the Great Moderation" keep investors and policymakers attuned to the risk that a bubble in bank loans, high yield bonds, or (scarier still) something we haven't identified could precipitate another crisis. Even more worrisome, Chair Yellen and other policymakers have admitted that accommodative monetary policy encourages investors to reach for yield, raising the prospect for financial instability in the future.

We won't get fooled again?

Both Congress and the Fed recognize this risk, but they're approaching the problem from two very different angles -- one, from Mars... the other, from Venus.

Congress seems to think the problem is bubbles. Listening to the Q&A in both the House and Senate, I was struck by how many questions Chair Yellen had to answer regarding the valuation of stocks, bonds, real estate... everything. Behind these questions lay the implication that the Fed should stamp out bubbles whenever and wherever they exist, so as to prevent the same spillovers we saw in 2008, when the collapse of the housing bubble nearly destroyed our financial system.

Bank loans... High yield... Social Media... Biotech...

But Yellen's focused on a bigger problem. She knows bubbles exist (she even singled some out) but, like most economists, Chair Yellen considers them a necessary -- albeit destabilizing -- byproduct of our capitalist system. We all hate it when bubbles pop, but economists realize the consequences aren't automatically devastating. Bubbles come and go all the time, and most of them pass without leaving a noticeable impression on the financial system or the real economy.

The enemy isn't bubbles per se -- it's the set of unchecked mechanisms and complicated linkages that transmit asset price collapses from one sector to another.

Generally speaking, the impact of a bubble bursting depends on a few factors: the relationship between individual markets and the real economy, the amount and distribution of leverage, and the responsiveness of central banks. The housing bubble was so destructive because its residue landed all over the commercial banking sector -- the engine of our economy and the hub of our financial system -- due to banks' high exposure to the housing sector and extreme reliance on short-term funding.

Source: The Economist

This is the problem Chair Yellen and other regulators are determined to solve. How do we ensure that a decline in asset prices (bank loans, high yield bonds, or anything else) leaves the financial system and the real economy intact? Maintaining financial stability isn't about limiting excesses; it's about preventing excesses from snowballing into a crisis.

That was the overriding goal of Dodd-Frank, and it's the motivation for Chair Yellen's renewed emphasis on macroprudential tools. David Moss, one of my favorite professors, said that financial regulation should keep systemically-important financial institutions on a tight leash, while allowing other institutions to innovate. Separating commercial banking from aggressive speculation is critical to ensuring that the next crisis leaves the pillars of our financial system intact. Rather than worrying about bubbles, we should be paranoid about getting the structure right.

Source: The Economist

This is why Congress should spend less time asking about valuations, and more time drilling Yellen on the Fed's progress in implementing Dodd-Frank and managing the issue of "too big to fail," the biggest threat to our financial system. Senator Elizabeth Warren deserves credit for raising TBTF in the context of JP Morgan's resolution plan, and Chair Yellen herself highlighted the Fed's efforts to improve supervision, enforce stricter capital rules, and maintain a healthier commercial banking system. These are the critical issues that policymakers should be discussing.

The dialogue in Washington (and on Wall Street) must evolve from guessing where the next bubble will arise to whether we've done enough to safeguard our system from the eventual fallout. Chair Yellen must offer a better definition of financial stability and explain how the structural reforms adopted in the aftermath of the financial crisis have made our system stronger. Otherwise, she and Congress will remain on two separate planets, leaving the financial reform process we once considered so important to fade quietly into outer space.