Reprinted with permission from EconomicPolicyJournal.com
Last week, the assorted regulatory freaks have been patting themselves on the back in front of your appointed financial elite, better known as the Financial Crisis Inquiry Commission. Our intrepid printer-in-chief himself made the rounds yesterday morning in the second appearance of his Whip Deflation Now TM tour. A translation of his first appearance has been kindly provided by Gary North (part 1, part 2).
We focus on Bernanke's remarks regarding monetary policy, wherein he dodges all responsibility for the Fed creating, then failing to identify, the housing bubble. Naturally, he concludes with allusions that the unprecedented interventionist structure being built will once and for all do away with that pesky business cycle. Before we give away too much, we'll let him dig his own grave.
Monetary Policy and Related FactorsSome have argued that monetary policy contributed significantly to the bubble in housing prices, which in turn was a trigger of the crisis. The question is a complex one [sic: beyond the limits of our Keynesian models], with ramifications for future policy that are still under debate; I will comment on the issue only briefly.The Federal Open Market Committee brought short-term interest rates to a very low level during and following the 2001 recession, in response to persistent sluggishness in the labor market and what at the time was perceived as a potential risk of deflation. Those actions were in accord with the FOMC's mandate from the Congress to promote maximum employment and price stability; indeed, the labor market recovered from that episode and price stability [sic: inflation in perpetuum] was maintained.Did the low level of short-term interest rates undertaken for the purposes of macroeconomic stabilization inadvertently make a significant contribution to the housing bubble? It is frankly quite difficult to determine the causes of booms and busts in asset prices; psychological phenomena are no doubt important, as argued by Robert Shiller, for example.8
Note: when your head is lodged within the box's colon, it's going to be a bit difficult to think outside of it and beyond your equation-scribbling peers--but yes, chalk it off to psychology and be done with it.
However, studies of the empirical linkage between monetary policy and house prices have generally found that that that linkage is much weaker than would be needed to explain the behavior of house prices in terms of FOMC policies during this period.9 [And just how many of these studies were written by those currently or formerly on the Fed's dole? Answer: nearly all.] Cross-national evidence also does not favor this hypothesis. For example, as documented by the International Monetary Fund, even though some countries other than the United States had substantial booms in house prices, there was little correlation across industrial countries between measures of monetary tightness or ease and changes in house prices.10 For example, the United Kingdom also experienced a major boom and bust in house prices during the 2000s, but the Bank of England's policy rate went below 4 percent for only a few months in 2003.
Well, everything's relative, isn't it:
Not that there weren't unique factors within the UK that facilitated a bubble relating to housing in particular, but it takes massive doses only of the world's reserve currency to achieve what Jeremey Grantham called in 2008 (as recently quoted by Paul Farrell), "The First Truly Global Bubble:"
From Indian antiquities to modern Chinese art; from land in Panama to Mayfair; from forestry, infrastructure, and the junkiest bonds to mundane blue chips; it's bubble time. ... The bursting of the bubble will be across all countries and all assets ... no similar global event has occurred before.
Congratulations, Fed--you own it all. With respect to the UK, it was especially vulnerable as it was a substantial profit reaper of US securitization efforts. Just what were those London bankers doing with their fees? Buying homes maybe?
The evidence is more consistent with a view that the run-up in house prices primarily represented a feedback loop between optimism [sic: increased inflation expectations as a result of Easy Al's print shop] regarding house prices and developments in the mortgage market. In mortgage markets, a combination of financial innovations and the vulnerabilities I mentioned earlier led to the extension of mortgages on increasingly easy terms to less-qualified borrowers, driving up the effective demand for housing and raising prices. Rising prices in turn further fueled optimism about the housing market and further increased the willingness of lenders to further weaken mortgage terms. Importantly, innovations in mortgage lending and the easing of standards had far greater effects on borrowers' monthly payments and housing affordability than did changes in monetary policy.11
While it's true that politicians lusting after votes created a legal framework over decades that allowed for the relaxation of lending standards to criminally low levels, and it's true that securitization efficiencies facilitated the rapid creation and transfer of credit, another truth is that rocket ships don't leave the ground without fuel. And, the fractional reserve rocket ship required the Maestro and his apprentice to conjure the digital zeros that would be sent out to be fruitful and multiply, thus doing Goldman's work. To be sure, this ship went parabolic in the 80's, but it was that final dose of nitrous in 2003-2004 that kicked off the asset backed securities binge, where everything from student loans to second mortgages to bookie receipts were sliced, diced, rated and sold as quickly as everyone's faith in perpetual asset price inflation would allow.
Source: Robert Prechter
The high rate of foreign investment in the United States also likely played a role in the housing boom. For many years, the United States has run large trade deficits while some emerging-market economies, notably some Asian nations and some oil producers, have run large trade surpluses. [Can anyone say Chinese/Saudi Dollar peg or BOJ intervention ad infinitum?] Such a trade pattern is necessarily coupled with [state enforced and manipulated] financial flows from the surplus to the deficit countries. International investment position statistics show that the excess savings of Asian nations [ah, the bane of Keynesians everywhere and always] have predominantly been put into U.S. government and agency debt and mortgage-backed securities [good dog], which would tend to lower real long-term interest rates, including mortgage rates. In international comparisons, there appears to be a strong connection between house price booms and significant capital inflows, in contrast to the aforementioned weak relationship found between monetary policy and house prices.12
Though, debunked prior, if there are any more doubts:
International investment position statistics show that the United States also received significant capital inflows from Europe in the years before the crisis. Europe's trade has been about balanced over the past decade or so, implying no large net capital flows on average. However, substantial gross flows occurred in the years running up to the crisis. Notably, European institutions issued large amounts of debt in the United States [and why wouldn't they with low rates and the continued promise thereof?], using the proceeds to buy private-sector debt, including securitized products. [Borrow low from Fed, lock in higher rates with Fannie/Freddie wink-and-a-nod-guaranteed debt and other "AAA" rated products. Seems like a no brainer.] On balance, the effect of these sales and purchases on Europe's capital account balance approximately netted out, but the combination led to growing European exposures to the kind of distress in U.S. private-sector debt markets that occurred during the crisis. The strength of the demand for U.S. private structured debt products [as a result of Al's predilection for bank philanthropy] by European and other foreign investors likely helped to maintain downward pressure on U.S. credit spreads, thereby reducing the costs that risky borrowers paid and thus, all else being equal, increasing their demand for loans.Even if monetary policy was not a principal cause of the housing bubble, some have argued that the Fed could have stopped the bubble at an earlier stage by more-aggressive interest rate increases. [or perhaps not lowering them thirteen times in a row the first place?] For several reasons, this was not a practical policy option. First, in 2003 or so, when the policy rate was at its lowest level, there was little agreement about whether the increase in housing prices was a bubble or not (or, a popular hypothesis, that there was a bubble but that it was restricted to certain parts of the country).
First, even before "2003 or so"--at the September 24, 2002 FOMC meeting to be exact--there was already discussion of the emerging "bubble" in housing, with the term used several times, including this curious exchange amongst the Committee recorded in the transcript (yes, the very type of transcripts that were once denied by Greenspan to exist):
[MS. BIES:] ...Rising house prices have sustained the consumer’s wealth position against falling equity markets, and any decline in house prices could have significant impacts on consumer spending. However, since I still have a house in Memphis for sale, I’m less inclined to believe that there’s a widespread bubble. [Laughter]MR. GRAMLICH. Is that house for sale?MS. BIES. Oh yes.VICE CHAIRMAN MCDONOUGH. Still.CHAIRMAN GREENSPAN. Are you bidding?MR. GRAMLICH. No, I’m just pointing out that there’s a bubble.
At the same meeting, Federal Reserve Bank of Atlanta president, Jack Guynn, said:
Although I would not yet characterize price developments in housing as a general housing bubble, I’m hearing more and more reports of what might be characterized as purely speculative housing and property deals, mostly in Florida. These deals are all driven by claims that sound as if the property can be resold in a few months or a few years at a nice profit so at current interest rates how can one pass up such an opportunity. Of course, there’s a bit of a Catch-22 in that these slow adjustments induced by low interest rates have served to sustain some measure of stability as the economy works through other adjustments. While I’m certainly not suggesting that we consider any policy tightening at this meeting, I do think we may already be in a bit of a policy trap. I recognize that some downside risks remain, including some potentially large and negative shocks, but I do not think we should exacerbate our long-term problem with still lower interest rates unless the downside risks loom larger or the negative shocks are realized. Thank you, Mr. Chairman.
The FOMC would go on to lower rates twice more, eventually to 1%, then keep them there for a year. Later, at the June 29-30, 2004 meeting, Mr. Guynn would say:
If I am correct, then we run the risk of pursuing a more accommodative monetary policy than we intend, with the likely outcome being a higher rate of inflation than expected. There’s a temptation to downplay the risk I’m raising. After all, the U.S. economy has functioned quite well with low inflation rates and with a negative real short-term rate, and some see continued resource slack as taking pressure off prices. But I suggest, given the recent combination of expansive fiscal and monetary policies, that our low inflation rate is most likely the consequence of heavy support for the dollar provided from abroad and a willingness on the part of foreigners to invest in this country, compensating for the low U.S. saving rate.
Accordingly, the connection between monetary policy and foreign investment, discussed previously, was expressed by at least one member of the FOMC. But, back to Bernanke, now:
Second, and more important, monetary policy is a blunt tool; raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy. In this case, to significantly affect monthly payments and other measures of housing affordability, the FOMC likely would have had to increase interest rates quite sharply, at a time when the recovery was viewed as "jobless" and deflation was perceived as a threat.
Here we see the central banker's innate twin fears of the falsely perceived "liquidity trap" and the CB's mortal enemy: deflation. For the record, Ben, the recovery was "viewed as jobless" precisely because the Fed serially over-accommodated through printing, and never let the bust part of the business cycle assume its proper role of adjusting for prior artificial accommodation. That is, Fed money printing so grossly exaggerated capital structures that securitization itself became an end, with the production of collateral secondary. (Indeed, toward the end, even collateral became unnecessary with such financial innovations as CDO squared).
A different line of argument holds that, by contributing to the long period of relatively placid economic and financial conditions sometimes known as the Great Moderation, monetary policy helped induce excessive complacency and insufficient attention to risk. Even though the two decades before the recent crisis included two recessions and several financial crises, including the bursting of the dot-com bubble, there may be some truth to this claim. [No, it is one of the truths.] However, it hardly follows that, in order to reduce risk-taking in financial markets, the Federal Reserve should impose the costs of instability on the entire economy.
Replace "reduce" with "induce", and one wonders what good purpose at all the Fed serves:
However, it hardly follows that, in order to induce risk-taking in financial markets, the Federal Reserve should impose the costs of instability on the entire economy.
Generally, financial regulation and supervision, rather than monetary policy, provide more-targeted tools for addressing credit-related problems. Enhancing financial stability through regulation and supervision leaves monetary policy free to focus on stability in growth and inflation, for which it is better suited. We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause; the FOMC is closely monitoring financial conditions for signs of such imbalances and will continue to do so. However, whenever possible, supervision and regulation should be the first line of defense against potential threats to financial stability.
In other words, the Fr-oddulently created Financial Stability Oversight Council and the Office of Financial Research will now paper over insolvency on an institution by institution basis, while the Fed will retain macro control over papering over system-wide insolvency.
While economists can call for the targeting of this-or-that inflation rate or this-or-that interest rate--credit aggregates, monetary aggregates, employment rates, etc.--the fact is, until business owners, especially small business owners, are unshackled from the institutionalized competitive advantages bestowed by the government upon their less efficient and better-connected rivals, prosperity for all will continue to decline. We could, as some suggest, force banks to lend by imposing a penalty on the $1 trillion in excess reserves held by banks at the Federal Reserve (as opposed to paying them 0.25% interest on such), which by the way, would lower interest rates further, not raise them--no matter how hard you wish. Just how much of this money would chase loans versus how much would be redirected into other investments is unknown. With the new myriad statutes, we're probably just a few short steps away from regulators forcing banks to make loans en masse to privileged groups that own small businesses. However, didn't we try this already with sub-prime? Sending unlimited good money after bad, cloaked in the "security" and moral hazard of government guarantees is what got us here. We don't need to "get money in the hands of consumers" or "make banks loan to small businesses", or advocate anymore madcap schemes for the Fed to implement. We need to let businesses figure out for themselves how to satisfy consumer demands on a fair playing field, and let consumers decide when they want to consume versus save. This does not require the gentle coaxing of the central planners. It precludes it.