Federal Intervention, the S&L Crisis, Mortgage-Backed Securities and Stagflation

My new column with J. Dustin Pope is up:

As Congress comes back from recess, the move towards increasing financial regulations will pick back up in earnest. From regulating hedge funds to widening the oversight roles of the Federal Reserve and Securities and Exchange Commission, we’re seeing a Washington power grab like never before. Treasury Secretary Tim Geithner has asked Congress to grant the government more authority, but before they do, lawmakers should take a look at history to see the consequences of past federal financial activism.

Before 1979, the Federal Reserve (Fed) used “interest rate targeting” as monetary policy to stimulate economic growth. But to manipulate interest rates the Fed would expand and contract the money supply in reaction to the market cycle. But because of the lag between this policy’s implementation and when it impacts the economy, the long-term ramifications were nearly impossible to predict. We now know that the unforeseen result of excessive growth in the money supply, combined with oil price shocks and price controls, ultimately resulted in 1970s “stagflation.”

To address this issue, then Fed Chairman Paul Volcker (now chairman of the President’s Economic Recovery Advisory Board), decided in October 1979 to annually increase the money supply at a fixed rate, essentially slowly increasing inflation in a predictable way. By slowly increasing the money supply annually and directly adjusting interest rates, lag effects become more stable. However, this policy of “inflation targeting” can result in wildly fluctuating interest rates—and that can have negative long-term consequences.

Bond prices move inversely to interest rates, and after Volcker’s monetary policy shift towards steady inflation in 1979, bond prices began fluctuate. Traditionally a conservative investment instrument, the destabilization of bond prices increased their potential value. This stability shift contributed to the emergence of junk bonds that, despite their high yield potential, carried a high risk of default and were partially to blame for the Savings and Loan Crisis in the 1980s.

Full Column Here