Bernanke, Angelides, and the Bank Tax: Part I

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On January 3, Fed chairman Ben Bernanke gave a long speech entitled "Monetary Policy and the Housing Bubble," in which he argued that the Fed's low interest rate policy in the early 2000s, which he supported, was not a significant factor in the housing bubble and resultant financial collapse. His arguments are unsound, self-serving, and harmful to economic recovery and financial regulatory reform.

John Taylor, in an op-ed in The Wall Street Journal on January 11, notes a number of the errors in the speech. Other errors have been pointed out in economists' blogs. The basic argument that Bernanke makes is that forecasted inflation at the outset of the 2000s was so low that pushing the federal funds rate way down (in fact, into negative territory in real--that is, inflation-adjusted--terms) was a prudent measure for stimulating the economy. And, Bernanke adds, although reducing the federal funds rate did lead to an increase in mortgage rates (even though the federal funds rate is short term and the mortgage rates long term at least in traditional 30-year fixed-payment mortgages, as distinct from the adjustable-rate mortgages that became popular during this period), the increase was too small to explain the extraordinary increase in housing prices. (So at least Bernanke acknowledges a link between short-run and long-run interest rates; his even more defensive predecessor as chairman of the Fed, Alan Greenspan, does not.)

The Fed's forecast was inaccurate (Taylor points out that private forecasts contradicted it). But accurate or inaccurate, the result was a huge increase in investment in housing, which pushed up housing prices. The increase in prices was inflationary. Negative interest rates are likely to cause inflation by flooding the economy with money, raising the ratio of money to output. The Fed was fooled because the flood of money, rather than creating a large surge in the consumer price index (in part because cheap foreign imports kept prices of most goods down), created asset-price inflation--and the principal asset inflated was housing. The Fed wasn't looking for asset-price inflation, and didn't see it.

Housing is a product bought primarily with debt (a long-term mortgage for between 80 and 100 percent of the market value of the house), so a fall in interest rates pushes up housing prices by increasing the demand for housing. It also leads to a reduction in mortgage standards, because when housing prices are rising, defaults decline, making risky mortgages less risky. In addition, very low interest rates stimulate lenders to make risky loans in order to maximize yield; hence house financing increasingly took the form of subprime mortgage lending. (When interest rates are very low, low-risk loans are not very profitable, and it is attractive to increase yield by making riskier loans.)

A housing bubble is extremely dangerous, as the Japanese learned in the 1990s. Mortgage debt is enormous, and entangles the banking industry deeply in the housing industry. Not all housing bubbles trigger collapses of the banking industry, of course, but a competent central bank would be alert to warning signals of a possible housing bubble. The Federal Reserve, first under Greenspan, then under Bernanke, was not alert; it was asleep.

Bernanke's claim that abnormally low interest rates cannot explain the entire increase in housing prices suggests a misunderstanding of the bubble phenomenon. A bubble is a self-sustaining increase in asset prices. People see prices rising, assume they will continue rising at least for a time, and jump on the bandwagon. An external stimulus, such as a continuing drop in mortgage interest rates, is not required to keep the bubble expanding. Bernanke acknowledges that "for a time, rising house prices became a self-fulfilling prophecy," but he argues that what got the bubble started was not low interest rates but the deterioration in lending standards. He does not acknowledge the possibility that low interest rates accelerated an existing trend to higher house prices, that rising house prices by reducing defaults led to riskier lending, that the search for yield in an environment of low interest rates also contributed to the increase in risky lending, and that these factors--all stemming from too-low interest rates generated by unsound monetary policy--were, in combination, responsible for the bubble.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.

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