Tuesday, January 5, 2010

Responses to Bernanke's Monetary Policy and the Housing Bubble speech...

Bernanke gave a recent speech, Monetary Policy and the Housing Bubble, Ben S. Bernanke, Chair, FRB. Economists Dean Baker and Mark Thoma have some thoughts on it.
 

The NYT reported on a talk by Federal Reserve Board Chairman Ben Bernanke in which he claimed that the low interest rates set by the Fed were not responsible for the housing bubble, but rather "lax regulation." This is taken as an exoneration of Mr. Bernanke's performance at the Fed. It isn't.

The Fed is the country's lead regulator. While the housing bubble was growing and bad mortgages were proliferating, Greenspan and the Fed insisted that everything was fine. Greenspan encouraged families to take out adjustable rate mortgages and did not even produce guidelines for mortgage issuance that banks had been expecting since the mid-90s. Greenspan and Bernanke also repeatedly disputed that there was anything out of the ordinary in the housing market, insisting that the run up in prices was driven by fundamentals.

Mr. Bernanke is absolutely right that low interests were not the cause of the housing bubble, but this hardly removes the Fed's responsibility. While all the regulators share some of the blame, the bulk of the blame for bad regulation lies with the lead regulator, the Fed.

 

Ben Bernanke says Federal Reserve interest rate policy after the dot.com bubble burst did not cause the housing bubble, and he delivers a strong rebuttal to John Taylor on that point. He argues the problem was with the regulation of these markets, not the low interest rates after the dot.com crash, and based upon this reading of the causes of the crisis, he believes regulation is the key to preventing bubbles. But he also acknowledges that if regulation fails to get the job done, then the Fed must step in and pop bubbles before they get too large by raising interest rates (though doubts are expressed about whether increasing interest rates would have done much to stop the bubble, hence the strong preference for regulatory solutions).

This is a big step forward relative to the Greenspan years. Greenspan argued that the Fed could not identify bubbles as they are inflating with sufficient clarity to allow policy to do much about them, he thought the Fed was as likely to do harm from raising interest rates based upon false bubble alarms as it was to prevent problems. And in any case, he believed that cleaning up after bubbles popped would be enough to avoid large downturns like we are experiencing. The best that the Fed could do given the difficulty in identifying bubbles ex-ante is to clean up after they self-identify by popping, but that would be more than enough to keep the economy from experiencing big crashes.

Greenspan's view that cleaning up ex-post would be sufficient to insulate the economy from large shocks turned out to be incorrect. He also resisted and actively dismissed regulatory interventions intended to keep the financial sector stable and keep bubbles from inflating in the first place, and this, too, was a mistake. In the past, Bernanke and other members of the Fed have also been resistant to using interest rate policy (as opposed to regulation) to prevent bubbles, so this is an evolution in the Fed's view of its role in preventing asset price bubbles from threatening the stability of the broader economy.

The Fed still strongly prefers regulatory solutions, the main problem with interest solutions are that bubbles are hard to identify, and even if you do identify them, interest rate increases affect all industries, not just the one experiencing the bubble, so the policy inflicts collateral damage (though perhaps less collateral damage than if the bubble actually pops). In this regard, I wish Bernanke would have talked about how the Fed might find better measures of growing financial market imbalances, measures that would allow it to better identify bubbles a priori. We can use interest rate and regulatory policy to fight bubbles much better and target policy more precisely if we have more certainty about the existence of bubbles as they are inflating, but that will require the Fed to develop much better measures of financial market fragility than it now has. (This is an alternative to incorporating asset prices into the index the Fed targets through its implicit Taylor rule, something that automatically raises interest rates when asset prices increase substantially and something that I've advocated in the past. Incorporating asset prices into the inflation index the Fed stabilizes is a very broad-brushed approach to the problem of fighting bubbles, so more targeted approaches are preferable). I realize that we have models saying it isn't possible to identify bubbles as they are inflating, but models aren't reality - they aren't always correct - and we won't really know until we try

Posted via email from Jim Nichols

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