There's a lot of talk this morning about a speech yesterday by Federal Reserve Chairman Ben Bernanke. At the annual meeting of the American Economic Association in Atlanta, he provided some concrete views on what caused the housing bubble. Several articles I've read about the speech imply that Bernanke is shoving off blame, since he says the Fed keeping interest rates extremely low shouldn't be faulted. But what he says did cause the mess should still keep the Fed in the hot seat. Yet, he's using it to ask for even more responsibility.
First, I'm not trying to agree that the Fed keeping rates so low had nothing to do with the housing bubble. I actually believe that played a role, but certainly shouldn't take on close to all of the blame. The more major cause according to Bernanke: not enough regulation. After a lengthy argument that rates weren't the problem, he says:
What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk-management practices without necessarily having had to make a judgment about the sustainability of house price increases.
My first observation is that this hardly deflects criticism. The Fed doesn't only wear a rate-setting hat; it's also a regulator. It could have stepped in and created rules for subprime mortgages, adjustable-rate mortgages, underwriting standards, etc. It didn't do so in time. So even if its rates setting policies didn't fail, its regulatory oversight certainly did.
Second, Felix Salmon makes an observation that I agree with regarding a paragraph following the one I quoted where Bernanke goes on:
The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country's overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.
Salmon says that he sees a power grab. Presumably, he thinks Bernanke really means something like, "Gee, look: if we could regulate more, then we could have avoided this whole mess." Salmon is probably right. Bernanke doesn't appear to so much be looking for absolution for messing up as he does to try to argue that the Fed should be able to do even more regulation.
I think that's nuts. The Fed already had sufficient power to regulate mortgage banking, yet it failed to do so. If it's given even more regulatory authority, such as systemic risk regulation, why do I have any reason to believe that it will do better next time? To me, this amounts to someone dropping a dozen eggs and saying that he will do better if he has to carry two dozen next time instead.
I've argued before, as the central bank the Fed has too many a conflicts-of-interest to be trusted to spearhead financial regulation. One of its major priorities is to protect banks. The moment that mission conflicts with sensible regulatory restraint, I worry that the Fed will defer to the banking industry's stance. You could even imagine back in 2004 that the Fed might have liked the housing boom and worried that full employment could suffer if the mortgage industry had more regulation. Which priority should it put first -- regulation or full employment?
While the Fed is talking loudly now about new regulation while we're in the recessionary trough with 20/20 hindsight, let's see if it will be as quick to create and enforce new regulations when happy times are here again. I remain highly skeptical.