Over in Perfect World, Janet Yellen was a sharp regulator who knows how to avoid market meltdowns smartly. In Perfect World, everyone noticed the Federal Reserve chairman's speech on July 2, where Yellen said she prefers not to raise interest rates as markets grow heated and bubbles start to appear in asset prices. A better approach, she argued, would be stronger regulation along the way to manage asset prices before bubbles get out of hand.

Nobody in Perfect World was scared when Yellen used words like “macroprudential approach” to discuss financial risks, even though that could have big implications for compliance and risks officers across the country. People  knew that the stock market was reaching new highs on Wall Street even as revenue growth poked along like a slug, wage growth sputtered, and all the jobs getting created were part-time. Everyone could see that home prices had been soaring, the bond market was brisk, and even risky markets Spain and Greece were courting investors again.

And why wouldn't that happen, after all? Interest rates had been so low for so long, investors had no choice but to pour money into any asset they could find to score just a bit more yield. Even in Perfect World, asset prices might start turning into bubbles that need attention.

In Perfect World, however, everyone also understood a fundamental truth that any five-year-old knows. Bubbles can grow bigger, but they never grow smaller—they just burst.

That's why Yellen wanted stronger regulation and a macroprudential approach to financial risks: to better control the size and pace of bubbles while they are inflating, and ideally prevent them ever from becoming too big in the first place. The alternative would be to raise interest rates after the bubble emerges, akin to pricking a bubble with a pin. Any five-year-old knows what happens then, too.

In Perfect World, then, Yellen's approach to financial risks meant stronger capital reserve rules for banks, and a more coordinated approach to regulation with central banks in Europe and elsewhere. It meant stronger enforcement from the Consumer Financial Protection Bureau, to prevent new abuses in mortgage lending or student loans. It meant closer oversight of centralized clearinghouses for derivatives trading, since lord only knows how much derivatives risk might get pooled into those trading facilities.

And everyone in Perfect World knew a macroprudential approach to regulation might be a pain but was worth it, because they had seen the financial crisis of 2008 and the mess you have to clean up otherwise.

Sigh. Good times there in Perfect World. Here in Real World, meanwhile, Yellen is going to testify this week in front of the House Financial Services Committee. Shall we guess how that conversation will go? 

Give credit to Yellen where it's due: she is charting her own course, one quite different from her predecessors. She saw firsthand the consequences of pricking asset bubbles with higher interest rates, first in the recession of 2001-02, and again with the mortgage meltdown and financial crisis of 2007-08. But also remember that higher interest rates only deflated asset bubbles (of stocks 1990s, home prices in the 2000s) that already existed. What caused those bubbles in the first place was lax regulation, fostered by business interests giving Washington money to do nothing.

That is the stronger tide Yellen must swim against. Doing so will not be easy.

As we wrote here a few weeks ago, the International Organization of Securities Commissions has a few ideas about new risks to the financial system. It sees complex retail products as one big risk, the “search for yield” as another. Just last week the markets were spooked by Espirito Santo, the Portuguese bank that kinda sorta looked like it might not be as financially healthy as the market believed. Closer to home, Washington continues to do not much about student loan debt, a $1.2 trillion pile of notes that nobody seriously expects to be paid in full.

In fact, let's take student loan debt as an example. For years banks have been handing out loans to almost any young person who asked, regardless of ability to repay. You think student loan debt isn't a systemic financial risk? Replace “student loan” with the word “bank,” and imagine the outcry of billions in debt never to be repaid short of taxpayer bailout.

We could have empowered the Consumer Financial Protection Bureau to police student lending more intelligently. Instead, Congress has attacked the CFPB at every turn, while debt piled up and young graduates defaulted. Who will make good on the difference? That would be you and me, John Q. Taxpayer. If you want a truly depressing example of the sorry state of regulation leaving taxpayers on the hook, read this New York Times column by Gretchen Morgensen about the lax oversight of Corinthian Colleges Inc.

Student loans, emerging market bonds, subprime mortgages. You can pick any number of asset classes and let a bubble emerge by lax regulation. Janet Yellen is trying to change that. Let's hope Congress gets out of her way. 

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