The housing bubble: In Bernanke’s defense?

Federal Reserve Chairman Ben Bernanke recently defended the Federal Reserve’s low-interest rate monetary policy which preceded the housing bubble in the United States. Bernanke instead pointed to a lack of regulatory controls as the major cause of the events which led to a breakdown of the system. Paul Krugman weighed in on the issue, agreeing that financial reform would be central to preventing another collapse of the financial system.

My friend Barry Ritholtz wrote Bubbles & Banks & Zero Lending Standard Loans, disagreeing with Krugman on sub-prime’s role in the crisis. In an e-mail exchange discussing the issue, U-Mass-Boston Professor Tom Ferguson said to us:

I understand Krugman as saying, implicitly, that deregulation gave you subprime. Not basically interest rates. I think he’s right. They needed not simply low rates, but the low standards to get the ridiculous numbers.

I’m with Tom on this one. In fact, it’s Bernanke’s view as well and I think it’s largely correct (probably the first time in history I’ve agreed with the Fed Chairman).  Of course, Bernanke’s newfound embrace of financial re-regulation is patently political.  If he can convince Congress that the problem was lack of oversight and regulation he can shift at least some of the blame to Treasury and Congress — since it was Treasury Secretary Rubin, and his protégé Summers, as well as Barney Frank, Christopher Dodd, and many others (significantly, Democrats who will now decide the Fed’s fate) who pushed through the deregulation bills in 1999 and 2000. He figures that if the Fed now supports re-regulation, he will be forgiven and the Democrats will be too embarrassed to admit their own misdeeds.

The financial deregulation, combined with tight fiscal policy (which forced people to go more into debt and use their homes as an ATM proxy, with these horribly toxic mortgages), was far more significant than low interest rates.

We had 9% interest rates in the 1970s and housing starts were higher than now with a smaller population.

I also think Randy Wray is right about this:

While I do believe the Fed should be stripped of all such authority, I am sympathetic to his argument about monetary policy. Low interest rates do not cause bubbles. The Fed kept interest rates low after the NASDAQ crash because it feared deflation in the face of significant downward pressures on wages and prices globally (see here). The belief was that low interest rates would keep borrowing costs low for firms and households, helping to promote spending and recovery. In truth, spending is not very interest sensitive and the economy stumbled along in a "jobless recovery" in spite of the low rates. What was actually needed was a fiscal stimulus (if anything, low rates are counterproductive because they reduce government interest spending on its debt—as Japan’s experience taught us over the past couple of decades—but that is a point for another blog).

Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!) The worst excesses in real estate markets began only after the Fed had started raising rates, and lending standards continued their downward spiral the higher the Fed pushed its target interest rate. In other words, contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets.

Why not? Two main reasons. First, recall that Greenspan had promoted adjustable rate mortgages with teasers. No matter how high the Fed pushed rates, lenders could offer "option rate" deals in which borrowers would pay a rate of 1 or 2 percent for two to three years, after which there would be a huge reset. Lenders ensured the borrowers that there was no reason to worry about resets, since they would refinance into another option rate mortgage before the reset. That is the beauty of ARMs—they virtually eliminate the impact of monetary policy on real estate.

Second, and this was the key, house prices would only go up. At the time of refinance, the borrower would have far more equity in the home, thus obtain a better mortgage. Further, the borrower could flip the house and walk away with cash. While I will not go into this now, public policy actually encouraged homeowners to look at their houses as assets, rather than as homes (see here) (And now that many are walking away from underwater mortgages—treating houses as assets that became bad deals—policy makers and banksters are shocked, shocked!, that borrowers are treating their homes as nothing but bad assets.)

In truth, when speculation comes to dominate an asset class, there is no interest rate hike that can kill a bubble. If one expects asset prices to rise by 20%, 30%, or more per year, an interest rate of 10% will not dampen enthusiasm. To kill the housing boom, the Fed would have had to engage in a Volcker-like double-digit rate hike (in the early 1980s, he raised short-term interest rates above 20%). There was no political will in Washington (either at the Fed or the White House) for such drastic measures. Nor was there any reason to do this. Bernanke is quite correct: the Fed could have and should have killed the real estate boom with much less pain by directly clamping down on lenders, prohibiting the dangerous practices that were rampant.

  1. demandside says

    To say that bubbles can happen without low rates is wrong. Low rates, easy money, cheap leverage is absolutely essential. One way to see if you are in a bubble is to see how easy money is to get. This is what makes the Fed’s blindness so nutso.

    There was a similar argument after the bust. Was the bubble a function of the cheap money and low margin requirements or was it the insider trading and manipulations? Well, it was both. The bubble began with rising asset prices. It grew when people began Ponzi financing, i.e., borrowing with the expectation of selling the asset at a higher price, not of financing it from any internal productive dynamic. And it mutated to disaster size when the ever less scrupulous took advantage of the fever.

    To me, the necessary and sufficient condition is the low rate. The steroid is the corruption. The boom incubates and promotes the steroid.

  2. Scott says

    “Still, the Fed was following conventional wisdom, and only began to gradually raise rates when job growth picked up in 2004. Over the following years, the Fed kept raising rates, and economic growth improved. (So much for conventional wisdom!)”

    I though conventional wisdom accepted that monetary policy impacts the economy in a lagging fashion. This linear argument as to rates are rising now but the economy is growing completely disregards that. It could just as easily be stated that easy monetary policy was still working its way through the economy during the early stages of the rate rising cycle and it took a while for the higher rates to work their way through the economy which eventually popped the bubble. Proposing that monetary policy is a “blunt” tool is reasonable as not only did it pop the bubble, but it also crashed the economy, but disreagarding it’s effects on the housing bubble altogether due to the fact that rates were rising while the economy was growing early in the recovery is hardly a convincing argument.

  3. Anonymous says

    The FED’s technical staff has always used the wrong criteria since c. 1965 (interest rates), as opposed to rates-of-change in legal reserves. Reserves exploded during Greenspan’s oversight. And legal reserves also exploded during Paul Volcker oversight. After Greenspan, Volcker conducted the 2nd easiest money policy in FED history.

  4. Anonymous says

    deja vu:
    • “contrary to what many are arguing, the Fed DID raise rates but this had no impact in real estate markets”
    • Our monetary mismanagement has been the assumption that the money supply can be managed through interest rates. Since c. 1965, the operation of the trading desk has been dictated by the federal funds “bracket racket” and thereafter by a series of interest rate pegs (even during Paul Volcker’s era).
    • This has assured the bankers that no matter what lines of credit they extend, they can always honor them, since the Fed assures the banks access to COSTLESS legal reserves, whenever the banks need to cover their expanding loans – deposits.
    • We should have learned the falsity of that assumption in the Dec. 1941-Mar. 1951 period. That was what the Treas. – Fed. Res. Accord of Mar. 1951 was all about
    • The effect of tying open market policy to a fed Funds rate is to supply additional (and excessive free gratis legal reserves) to the banking system when loan demand increases.
    • Since the member banks have no excess reserves of significance the banks have to acquire additional, & free, reserves to support the expansion of deposits, resulting from their loan expansion.
    • If they use the fed funds market, which is typical, the rate is bid up and the “trading desk” responds by putting through buy orders, COSTLESS reserves are increased, and soon a multiple volume of money is created on the basis of any given increase in free legal reserves.
    • Apparently, the Fed’s technical staff either never learned, or forgot, how Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between.
    • This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation. The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort.
    • This plus controls on prices and wages kept the reported rate of inflation down. Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.
    • The money supply, or monetary flows (our means-of-payment money times its rate of turnover) can never be managed by any attempt to control the cost of credit:

  5. sherry says

    This column is somewhat misleading in that, for example, Barney Frank voted against the bill that repealed Glass-Steagal. Democrats, early-on, wanted to regulated the CDO’s, etc. Remember, democrats were not in the majority as this all unfolded.

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