As the crypto mania continues to spread into financial markets, now at “real companies” like Eastman Kodak and Seagate Technology, policymakers are going to grow more concerned about broader implications for financial markets and the real economy.
Is cryptocurrency exuberance a sign of financial market froth more broadly? If so, that could trigger concerns about financial stability and justify an accelerating pace of rate hikes from the Federal Reserve. But rather than that knee-jerk response, this moment presents the Fed, policymakers and Wall Street with an opportunity to correct mistakes from the last cycle and -- rather than over-tighten monetary policy to cool off one area of the economy -- to use targeted regulation instead.
That mistake of the last cycle was responding to the credit and housing bubble by increasing interest rates rather than simply cracking down on bad behavior in housing and credit markets. Relative to other cycles in history, the economy as a whole was barely overheating at all at the peak. The unemployment rate never fell below 4.4 percent, a higher level than it stands at today. While the Fed didn’t have a formal inflation target at that point, the metric it currently uses for inflation spent only a handful of months over 2 percent. In its rate-tightening cycle, the Fed policy mistake was raising interest rates too quickly, not too slowly.
Where the Fed fell short was in not regulating the problem areas. Underwriting standards for mortgages were too lax. Exotic mortgages were too prevalent. Leverage throughout the financial system was too high. If we had had more prudent underwriting and lending standards, and a less leveraged financial system, we could have had a longer, more balanced economic expansion, one less susceptible to a financial crisis.
It’s unclear whether cryptocurrencies pose any risk to financial markets or financial system stability at this point, but if policymakers want to protect against the possibility, they should do so on the regulatory side, not the monetary policy side. It was heartening to see a handful of prospective bitcoin ETFs hit a regulatory stumbling block this week over concerns about liquidity and valuation of the underlying instrument. More concerning was seeing Long Blockchain -- the company that days before had changed its name from Long Island Iced Tea -- respond to the jump in its stock price by seeking to issue $8 million in equity.
In the go-go days of the dot-com boom, the attitude to situations like Long Blockchain may have been “caveat emptor,” but in a world where assets are flowing out of actively managed funds into passively managed funds, perhaps philosophies should be different for companies that are a part of major indices. Eastman Kodak, for instance, is a part of the Russell 2000 Index, which has tens of billions of dollars in exchange-traded funds tracking it. It represents a microscopic part of that index, but as long as companies see their stock prices surge from cryptocurrency or blockchain-related announcements, expect more such announcements, perhaps for even higher-profile companies. If the financial industry is going to recommend that individuals stop doing due diligence on individual companies and leave their money in funds tracking the broader market, then it becomes more important for indices and passive vehicles to think about standards for inclusion in those indices and vehicles, to prevent some of the gaming we’re starting to see.
Wall Street and the Federal Reserve prior to the great recession had a tendency to fight regulation, saying it slowed economic growth. But that’s not looking at the whole picture, particularly at a point in the economic cycle like we’re in today. The Fed believes we’re at full employment. Financial conditions are loose. Officials see what’s going on with cryptocurrencies. They want to raise interest rates at a gradual pace, and as long as measures of wage growth and inflation don’t show overheating, they have the mandate to proceed accordingly. But if they felt like cryptocurrency-related froth was too much for them, and they decided to accelerate the pace of rate hikes to cool off speculative excess, then that monetary tightening would have a far greater negative impact on growth in the real economy than would a little targeted regulation.
The last two economic cycles were short-circuited not by economic overheating, but rather by excessive tightening by the Federal Reserve inspired by speculative excess in financial markets (dot-com stocks in the late 1990s, housing and credit in the mid-2000s). Monetary policy tightening should be reserved for true excess in the real economy. Next time the Fed sees bubble-like behavior in one area of markets, it should be dealt with specifically, with minimal collateral damage.
By Conor Sen
Conor Sen is a Bloomberg View columnist. -- Ed.
(Bloomberg)
