The Next Bubble?

Scary words from economist Simon Johnson:

By not changing incentives for powerful bank insiders, we are lining ourselves up for another big “moral hazard trade” – think of this as a bailout by the Federal Reserve of everyone, but especially banks. Current and future bank executives will take risk again – but next time it will be risk with the public’s money. A housing bubble led to the current difficulties but the meta-bubble is a rise in financial services as a share of the economy, which has been underway since the 1980s. In the latest manifestation of the ensuing shift in economic and political power towards the financial sector, an unsustainable “Fed bubble” is potentially underway. This may lead to outcomes that are considerably worse than what we have seen so far. [E.A.]

Johnson is a proponent of revised regulation for the financial industry, and he is optimistic that the will exists to make it happen. If there was some way to insure that we implement the correct regulation, rather than just any regulation, I might share some of his zeal for a new regulatory regime.

There are two major hurdles to this outcome. First, it is difficult, if not impossible, to know for certain what the optimal regulatory scheme is. Second, even if it were knowable, the reality of our political system may make implementation impossible.

Given this, I am even more frightened by his warning regarding the existence of a Fed bubble, and what its end might mean for the economy.