Federal Reserve chairman Ben Bernanke's speech on Sunday on monetary policy and the housing bubble did not exactly go unnoticed by the public.
In his speech at the annual meeting of the American Economic Association in Atlanta, Georgia, Bernanke tried to explain how the Fed's monetary policy had been conducted in the early to mid 2000s and how it affected the housing market. He essentially concluded that monetary policy was more or less appropriate for the conditions prevailing but that regulation could have been improved to prevent the housing bubble.
In looking at the link between monetary policy and the rapid rise in house prices, Bernanke concluded that the "direct linkages, at least, are weak". He claimed that "the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone".
Instead, Bernanke suggested that "the best response to the housing bubble would have been regulatory, not monetary". He noted that the increased use of more exotic types of mortgages and the associated decline of underwriting standards meant that stronger regulation and supervision of underwriting practices and lenders' risk management would have been a "more effective and surgical approach to constraining the housing bubble".
Many were not convinced by Bernanke's arguments, to say the least.
Barry Ritholtz at The Big Picture rejected Bernanke's absolution of monetary policy. "But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields," he pointed out. "Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates."
And Paul Krugman pointed out in his column in The New York Times that focusing on unconventional mortgages is "awfully 2007". He wrote: "We now know that many perfectly conventional mortgages went bust; we know that commercial real estate was at least as overblown as housing."
On the same point, Stefan Karlsson said that many other countries with housing bubbles did not have exotic mortgages.
Apart from his point that the rise in house prices seemed too large to be accounted for by low interest rates alone, Bernanke's defence of monetary policy rested on the premise that it had conformed with the prescriptions of the Taylor Rule.
To this, Mike Shedlock at Global Economic Trend Analysis pointed out that "there is considerable disagreement over what [the Taylor Rule] says". For example, once the Case-Shiller Housing Index is substituted for owners' equivalent rent in the consumer price index, the inflation rate would have been shown to be much higher than the official rate from 2002 to 2005, making monetary policy appear looser.
To be fair, though, in my opinion, Bernanke was not saying that monetary policy had no role in the housing bubble. At the end of his speech, he actually made a tacit acknowledgement that low interest rates were a factor behind the housing bubble when he said that "if adequate [regulatory] 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".
Ultimately, Bernanke's main message was probably that regulation is a better tool for dealing with bubbles than monetary policy, which should focus on stabilising macroeconomic conditions. However, this message would probably have been more readily accepted if he had not appeared so eager to exonerate the Fed on its monetary policy.
Instead, he should probably have done what Krugman suggested, which was to be "more forthright about the Fed’s undoubted failures: Greenspan’s rejection of advice about the risks of subprime lending, and the failure of top officials, BB included, to recognize the housing bubble in real time."
One thing that Bernanke only briefly touched on in his speech but might well have been an important factor in the housing bubble is the global savings glut hypothesis. He showed that between the fourth quarter of 2001 and the third quarter of 2006, countries in which capital inflows rose had greater house price appreciation.
In fact, if he had gone back further, he could have shown that the US current account deficit started to expand in a persistent manner around the mid-1990s, roughly the same time that US house prices started to accelerate. In those days, Fed monetary policy had not been extraordinarily loose. In fact, the Fed had tightened monetary policy in 1994.
However, significant events were unfolding elsewhere.
In 1994, China devalued the renminbi. The value of its foreign exchange reserves, which had been growing only slowly before, more than doubled that year and has not looked back since.
In 1995, the Bank of Japan cut interest rates below 1 percent. The yen carry trade is widely considered to have begun that year.
So capital inflows from elsewhere were arguably the main drivers of increased financial liquidity in the 1990s.
And yet, entering the 2000s, the Fed could do little to offset the increased liquidity with tighter monetary policy because the US economy entered a recession in 2001 that was followed by a jobless recovery.
Caught between a rock and a hard place, the Fed chose to lower rates pre-emptively anyway, turning monetary policy in the early 2000s even looser than the 1990s and exacerbating liquidity conditions. This essentially risked long term financial instability for the sake of short-term economic stability.
To make things worse, throughout the early 2000s, the Fed under then-chairman Alan Greenspan resisted attempts to increase regulation of the financial sector, something that Bernanke acknowledged in his speech might have helped mitigate the excesses.
As things went, the fed funds rate hit a low of 1 percent in 2003, which was about when the housing bubble began its blow-off stage.
So if countries like Japan and China planted the seeds of the housing boom, the Fed watered the seeds and ensured that it grew into a bubble.
Today, the US, Japan and China are the three biggest economies in the world. It does not seem unfair to me to suggest that all three share the bulk of the blame for the bubble.
In any case, we probably need to move away from the idea that we can pin all the blame for the bubble on just one factor and one party.
