(repost from January 4, 2010)
Yesterday, Federal Reserve Chairman Ben Bernanke spoke at the annual meeting of the American Economic Association in Atlanta, Georgia. In his speech titled “Monetary Policy and the Housing Bubble,” Bernanke presented statistical (econometric) analyses to demonstrate that monetary policy contributed very little to the recent housing bubble in the U.S. and in other industrialized countries. He also asserted that tighter monetary policy would have had little impact on the use of adjustable-rate mortgages (ARMs) in financing home loans, a financial product whose “…availability…proved to be quite important and, as many have recognized, is likely a key explanation of the housing bubble.”
Moreover, Bernanke presented statistical evidence that capital inflows contributed more to housing bubbles around the globe than monetary policy. These capital inflows were part of the “savings glut” that sent money from emerging economies with high savings rates to industrialized economies chock full of borrowers and spenders. Finally, Bernanke concluded that regulatory policies are more effective than monetary policy for deflating asset bubbles because regulators can work in a much more targeted and focused fashion than interest rates which touch the entire economy.
Bernanke also went into a technical discussion of the Taylor Rule. The Taylor rule sets central bank interest rates using the gap between current inflation and an inflation target and the gap between current economic output and the economy’s “potential” output. Critics of the Fed have often used this rule to assert that monetary policy was overly accomodative in the years following the 2001 recession. Bernanke provided a chart showing that using inflation forecasts in the Taylor Rule demonstrates that monetary policy was not overly accomodative. Moreover, a simple rule can only provide a guideline and cannot substitute for complete policy analysis.
Some of these arguments have appeared in other speeches and other places before. One particularly noteworthy development from this speech is that Bernanke claimed the Federal Reserve is willing to consider the use of monetary policy to deflate asset bubbles.
Below, I provide my own spin and opinion on some of Bernanke’s assertions. All quotations come from Bernanke’s speech except where otherwise noted.
“The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up.”
Bernanke includes a chart showing that housing prices increased every year since 1978 except in 1991 (slide #5). The rate of increase trended upward starting in 1992. Why did it take so long for market participants to conclude that housing prices would only go up and believe this to such an extent that lending standards notably declined? Bernanke does not attempt to explain this dynamic and appears comfortable implying that market psychology spun out of control on its own. I would instead like Bernanke to consider what impact the Federal Reserve had on this market psychology when the Fed demonstrated a consistent willingness to bail out failed (and/or weakening) financial institutions (the “Greenspan put”), and its insistence after the 2001 recession that monetary policy would remain accomodative for quite some time. I believe we should consider whether Federal Reserve actions that imply financial markets contain little risk encourage the risky behaviors the generate bubbles.
“…countries in which current accounts worsened and capital inflows rose…had greater house price appreciation…This simple relationship requires more interpretation before any strong conclusions about causality can be drawn; in particular, we need to understand better why some countries drew stronger capital inflows than others. I will only note here that, as more accommodative monetary policies generally reduce capital inflows, this relationship appears to be inconsistent with the existence of a strong link between monetary policy and house price appreciation.”
Bernanke may be missing an extra layer of analysis. A central bank establishes more accomodative monetary policy in large part to support and prop up consumption in the economy. If that economy also imports substantial quantities of goods from countries with relatively low production costs, then propping up consumption allows these exporters to continue accumulating savings. Even if these savings grow at a slower rate due to inflating import prices, the factors that drove the capital inflows may continue given the persistence of the “savings glut.”
“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.”
After this quote, Bernanke goes on to mention efforts the Federal Reserve made starting in 2005 to get lenders to tighten standards. He concludes: “…these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.” Bernanke fails to contemplate that these efforts failed primarily because the Federal Reserve long refused to recognize that a bubble existed in the housing market; judgments about the sustainability of house price increases had become intertwined with rationale supporting lending and risk management practices. During the early years of the bubble, the Federal Reserve encouraged a consensus amongst market participants that price increases were rational given macroeconomic conditions. For example, how could the Fed motivate any sense of urgency or responsibility amidst lenders and regulatory actors while Alan Greenspan, the Fed chairman at the time, issued conflicting statements about the existence of a housing bubble as late as 2005 (his last full year with the Fed). Worst of all, Greenspan suggested in 2005 that any price declines in the housing market would “only” impact the late-comers to the party (the proverbial “bag holders”):
“…when home prices slow, only those who purchased homes just as the prices begin to drop will be impacted by the decline. The number of occasions in which an average level of prices in the United States have actually gone down are very rare. Even if there are declines in prices, the significant run-up to date has so increased equity in homes that only those who have purchased very recently, purchased just before prices actually literally go down, are going to have problems. The presumption that there are a lot of bankruptcies out there doesn’t seem credible to any of my associates and myself.”
I am not surprised that the Federal Reserve was so ineffective in motivating financial institutions to pull away from the seduction of the housing bubble.
Bernanke issued a common refrain in his speech describing the difficulty in fighting asset bubbles:
“Although the house price bubble appears obvious in retrospect–all bubbles appear obvious in retrospect–in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets.”
In other words, the Federal Reserve may always feel paralyzed whenever it tries to stare down a bubble.
I will at least give Bernanke credit for noting that asset bubbles cause significant economic damage and warning, however weak the warning appears, that if all else fails, the Federal Reserve maintains the option to use monetary policy to thwart bubbles (even if they paradoxically remain impossible to define!):
“…having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks–proceeding cautiously and always keeping in mind the inherent difficulties of that approach.”
Be careful out there!
Full disclosure: no positions