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.
Bernanke exonerates monetary policy, and places blame instead on the lenders for risking lending, on the "global savings glut" (the increase in the U.S. monetary supply because of large purchases of Treasury securities by China and other countries that have large dollar reserves because they export much more than they import), and on imperfect execution by bank regulators (including the Fed) of their authority to prevent risky lending. Higher interest rates that would have burst the housing bubble would also, he argues, have slowed economic activity in general, and better regulation of risky lending practices would not, and so his preferred combination would be very low interest rates with stricter regulation of banks (and other lenders). But stricter regulation of lending would have reduced the amount of credit available in the economy, which would have slowed economic activity. As for the availability of foreign capital, while it facilitated investment in housing, it did not disable the Fed from raising interest rates, as it finally did, to burst the bubble--after the bubble had become so large that its bursting was a disaster.
I am unclear why Bernanke is so defensive about monetary policy, while acknowledging (albeit very briefly) failures of regulation for which he also bears considerable responsibility. The regulatory failure, however, is shared with other regulatory agencies, such as the SEC. And the regulation of the money supply (and hence of interest rates) is the very core of the Fed's responsibilities; if it is incompetent at that task, it may require some profound overhaul.
Another regulatory failure goes unmentioned. Even if the Fed's monetary policy was not responsible for the bubble, the Fed should have been alert to the possibility of a bubble, and should have taken measures either to burst it before it got too large, or to insulate the banking industry from the consequences of a burst. The Fed--Greenspan's Fed, Bernanke's Fed--was asleep at the switch.
The timing and content of Bernanke's speech cannot be separated from his uncomfortable position of being up for confirmation by the Senate for a second term as chairman of the Fed. He bears, in my opinion, a considerable responsibility for the current dreadful state of the economy, not only by his lack of foresight concerning the housing bubble and his complicity in Greenspan's mismanagement of monetary policy, but in his failure to grasp the severity of the looming financial crisis even after Bear Stearns collapsed in March 2008. The result of that failure was that he was taken by surprise when the other financial ninepins fell in September and failed to grasp the importance of keeping Lehman Brothers from collapsing. He then regained his balance. But much damage to the economy had been done.
It is natural, especially while the Senate's determination whether to confirm him is pending, that Bernanke should avoid accepting blame for the economic mess we're in. But it has the bad effect of feeding the populist theory of the economic depression--that it was the work of greedy and reckless bankers. Of course it was the collapse of the banks that triggered the depression, and the collapse was the proximate result of decisions made by the bankers. But as I argue in my new book (in fact in both books), the bankers were doing what businessmen always do, which is to try to maximize profits within the framework of permissible profit-maximizing conduct created by government. Because government regulation of the money supply and of lending practices was defective, the bankers' pursuit of profit maximization led the economy over the brink. If the framework is not reformed, we are at risk of experiencing a future financial crisis of equivalent severity to this one. Bank taxes and limitations on bankers' compensation may assuage the public anger stirred up by a populist theory endorsed by government officials, but they will not prevent future crises.
Photo credit: Win McNamee/Getty Images
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