Federal Reserve Chairman Ben Bernanke spoke last Sunday, January 3, 2010 at the Annual Meeting of the American Economic Association in Atlanta Georgia. His speech covered monetary policy and the housing bubble, specifically looking at causes of the housing bubbles and lessons that can be learned. While it is highly academic and historical, it provides valuable insight into Bernanke’s attitude toward monetary policy and what to expect. It also comes across as defensive, which is not surprising at a time when people and Congress are upset with the Fed and calling for changes such as audits.
Readers can find the entire speech here.
As Bernanke says during his speech, “a great deal more than historical accuracy rides on the resolution of this debate.” The lessons people, central bankers, and governments take away from this worldwide economic crisis will influence future policy and thus shape our economic future. Correctly identifying the causes will result in valuable lessons that will remove the harmful cause and greatly increase the chances for prosperity in the future. Incorrectly identifying the causes will allow the harmful cause to remain. Further, it would produce false lessons that are likely to further harm the economy.
Was Greenspan’s Aggressive Monetary Policy Appropriate?
In his evaluation of prior monetary policy, Bernanke spoke on the aggressive monetary policy response in 2002 and 2003. One principal factor was, “although the recession technically ended in late 2001, the recovery remained quite weak and “jobless” into the latter part of 2003. Real gross domestic product (GDP), which normally grows above trend in the early stages of an economic expansion, rose at an average pace just above 2 percent in 2002 and the first half of 2003, a rate insufficient to halt continued increases in the unemployment rate, which peaked above 6 percent in the first half of 2003.”
Fast forward to today and we find ourselves in a similar situation. Some might argue the recession technically ended already, but even if not, that would just encourage further or continued easing from the Fed. The US recovery is quite weak, unemployment is over 10%, and GDP is just above 2 percent.
Bernanke attempts to justify that the conditions back then called for aggressive monetary policy well after the recession ended. Through his academic journey of the Taylor rule, he concludes, “monetary policy following the 2001 recession appears to have been reasonably appropriate, at least in relation to a simple policy rule.”
Therefore, at least in terms Fed’s goals regarding maximum sustainable employment, price stability, medium term inflation, and output, Bernanke feels justified and will once again keep interest rates very low even after the recession may technically be over. Readers may be interested in another IntegrityFX article, Timeline: End of Recessions and Fed Rate Hikes, which comes to a similar conclusion.
What Caused the Housing Bubble?
Fortunately Bernanke separates the appropriateness of the 2002 and 2003 aggressive monetary policy from whether or not it contributed to the housing bubble.
Bernanke pinpoints the cause, or at least one major factor of it, on adjustable rate mortgage (ARM) products. There certainly was a large shift and increase in ARMs during the housing bubble, which resulted in smaller payments in the short term and increase demand as housing prices were increasing. However, that was a symptom, not the cause. The cause was what Bernanke is fighting so hard against, excessively low interest rates. As he said himself, the Fed’s exceptionally low rates caused ARMs to also have exceptionally low rates. “Low policy rates feed through to monthly mortgage payments more directly when the mortgage interest rate is adjustable and tied to short-term rates. This linkage could rationalize a stronger effect of monetary policy on house prices in the more recent period.”
He then goes on to argue against that rationalization, attempting to show that monetary policy played no role in creating the housing bubble. However, in doing so, he uses hypothetical information in economic models which he just earlier in his speech stated was conjectural. Also, his cross country evidence doesn’t amount to much. Different countries were in different conditions at the time, and bubbles aren’t always uniform, they can arise in different sectors or spread out through many.
Oddly enough, Greenspan, as Fed Chairman in February 2004, said fixed rate mortgages were costing Americans more and suggested that they would benefit from ARMs. So the Federal Reserve was previously advocating what they are now blaming on the housing bubble.
The real cause is not too difficult to understand. Excessively low interest rates from the Fed caused interest rates to be very low in other products and sectors. This incentivized risk taking and caused bad investments, which happened to manifest in the housing sector through ARMs, caused an unsustainable boom, and inevitably burst. Without excessively low rates, ARMs would not have had such low rates, risk taking would not have been incentivized, and there would not have been a housing bubble. For a deeper analysis, see the Austrian theory of the business cycle, which is explained and applied to the housing bubble in the book Meltdown by Thomas E Woods Jr. Keep in mind Austrian economists correctly identified and warned of the housing bubble at its beginning, while Bernanke dismissed it at its height when it began to burst.
Conclusion and Policy Implications
Despite whether one subscribes to the Austrian school of economics, or the Keynesian school, or any at all, Bernanke made two of his beliefs clear. First, that holding at extremely low interest rates well after a recession has ended is appropriate. Second, that holding at extremely low interest rates doesn’t have unintended consequences such as inflating asset bubbles. If one holds those values to be true, then excessively inflating the money supply for a significant period of time is the tool of choice. This is why the Fed is greatly inflating the supply of US dollars and will continue to do so. This is why the US dollar has been weakening and will continue to do so. This is why you can ignore speculation of the Fed raising rates anytime soon. And this is why, until the Fed and government turn away from this approach, I will continue to be bearish the US dollar.
