Federal Reserve Policy and the Housing Bubble
TL;DR: The U.S. housing bubble and the fallout from its bursting are not the results of a laissez-faire monetary and financial system as mentioned in this paper, but the result of poorly chosen public policies that distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions.
Abstract: The U.S. housing bubble and the fallout from its bursting are not the results of a laissez-faire monetary and financial system. They happened in an unanchored government fiat monetary system with a restricted financial system. What Happened and Why? Our current financial turmoil began with unusual monetary policy moves by the Federal Reserve System and novel federal regulatory interventions. These poorly chosen public policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions. There is no doubt that private miscalculation and imprudence have made matters worse for more than a few institutions. Such mistakes help to explain which particular firms have run into the most trouble. But to explain industry-wide errors we need to identify price and incentive distortions capable of having industry-wide effects. Here I will make two main points. First, the Federal Reserve's expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing. Elsewhere (White 2008) I have discussed the growth in regulatory mandates and subsidies that exaggerated the demand for riskier mortgages, most importantly the implicit guarantees to Fannie Mae and Freddie Mac that combined with HUD's imposition of "affordable housing" mandates on Fannie and Freddie to accelerate the creation of a market for securitized subprime mortgages. (1) Second, the Federal Reserve has undertaken self-initiated new lending roles that constitute a shadow bailout program more than twice the size of the Treasury's $700 billion bailout program. There is unfortunately little evidence that the Fed's new lending has helped to resolve our financial problems, rather than to delay their resolution. The Credit Supply Bubble Some authors, considering the relationship of Federal Reserve policy to asset bubbles, ask only: Should the Fed actively burst a growing bubble? If so, how? As posed, their questions suggest that asset bubbles arise independent of monetary policy, and the only Fed role to be discussed is that of bubble-buster. A more important pair of questions is: Does Fed policy as currently conducted tend to inflate assets bubbles? If so, how can we reformulate policy to avoid that tendency? Call our objective a non-bubble-prone or "non-effervescent" monetary policy. The economics profession has not reached a consensus on what the optimally non-effervescent monetary policy is, but it is now widely agreed that it isn't holding interest rates too low for too long. It should also now be clear that a Fed policy that deliberately ignores asset prices, as though consumer prices alone were a sufficient indicator of excessive Fed expansion, is also not the way to avoid inflating asset bubbles. In the recession of 2001, the Federal Reserve System under Chairman Alan Greenspan began aggressively expanding the U.S. money supply. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed's repeatedly lowering its target for the federal funds (interbank overnight) interest rate. The Fed funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. The Greenspan Fed reduced the rate further in 2002 and 2003, pushing it in mid-2003 a record low of 1 percent, where it stayed for a year. The real Fed funds rate was negative--meaning that nominal rates were lower than the contemporary rate of inflation--for an unprecedented two and a half years. A borrower during that period who simply purchased and held vacant land, the price of which (net of taxes) merely kept up with inflation, was profiting in proportion to what he borrowed. How do we judge whether the Fed expanded more than it should have? One venerable (albeit no longer popular) norm for making fiat central bank policy as neutral as possible toward the financial market is to aim for stability (zero growth) in the volume of nominal expenditure. …
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TL;DR: In this paper, the authors conduct an econometric investigation of the existence of bubbles in the bitcoin market based on a recently developed technique that is robust in detecting bubbles, that of Phillips et al. (2013a).
Abstract: The creation of bitcoin heralded the arrival of digital or crypto-currency and has been regarded as a phenomenon. Since its introduction, it has experienced a meteoric rise in price and rapid growth accompanied by huge volatility swings, and also attracted plenty of controversies which even involved law enforcement agencies. Hence, claims abound that bitcoin has been characterized by bubbles ready to burst any time (e.g. the recent collapse of bitcoin’s biggest exchange, Mt Gox). This has earned plenty of coverage in the media but surprisingly not in the academic literature. We therefore fill this knowledge gap. We conduct an econometric investigation of the existence of bubbles in the bitcoin market based on a recently developed technique that is robust in detecting bubbles – that of Phillips et al. (2013a). Over the period 2010–2014, we detected a number of short-lived bubbles; most importantly, we found three huge bubbles in the latter part of the period 2011–2013 lasting from 66 to 106 days, with the ...
294 citations
Cites background from "Federal Reserve Policy and the Hous..."
...According to White (2009), this stock market boom and bust was actually accompanied by the same situation in the real estate market....
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TL;DR: The authors proposed the standardization of private-label mortgage-backed securities (PLS) as an information-forcing device to encourage accurate risk pricing, which is necessary to rebuild a sustainable, stable housing-finance market.
Abstract: There is little consensus as to the cause of the housing bubble that precipitated the financial crisis of 2008. Numerous explanations exist: misguided monetary policy; a global savings surplus; government policies encouraging
affordable homeownership; irrational consumer expectations of rising housing prices; inelastic housing supply. None of these explanations, however, is capable of fully explaining the housing bubble.
This Article posits a new explanation for the housing bubble. First, it demonstrates that the bubble was a supply-side phenomenon attributable to an excess of mispriced mortgage finance: mortgage-finance spreads declined and
volume increased, even as risk increased—a confluence attributable only to an oversupply of mortgage finance.
Second, it explains the mortgage-finance supply glut as resulting from the failure of markets to price risk correctly due to the complexity, opacity, and
heterogeneity of the unregulated private-label mortgage-backed securities (PLS) that began to dominate the market in 2004. The rise of PLS exacerbated informational asymmetries between the financial institutions that intermediate
mortgage finance and PLS investors. These intermediation agents exploited informational asymmetries to encourage overinvestment in PLS that boosted the financial intermediaries’ volume-based profits and enabled borrowers to bid up housing prices.
This Article proposes the standardization of PLS as an information-forcing device. Reducing the complexity and heterogeneity of PLS would facilitate accurate risk pricing, which is necessary to rebuild a sustainable, stable housing-finance market.
134 citations
Book•
15 Jul 2014TL;DR: Koppl as mentioned in this paper argues that the missing ingredient in many economic theories is a proper theory of "confidence", which is needed in any economic framework that is to explain one of the most important periods in modern economic history.
Abstract: Some would argue that the financial crash revealed failings in the discipline of economics as well as in the financial system. The main post-war approaches to economics, based on neo-classical and new- Keynesian principles and modelling, failed to anticipate the crash or the depth of the slump that followed. In this monograph, Roger Koppl, drawing on ideas from the Austrian school and the work that has been done on policy uncertainty argues that the missing ingredient in many economic theories is a proper theory of "confidence". The author is not only able to make sense of Keynes' "animal spirits", but also demonstrates how "Big Players" - often, though not always, government agencies - can undermine confidence, reduce long-term investment, increase speculation and reduce economic growth over a long period of time. From crisis to confidence not only describes the process through which the economy must go through before a full recovery after the financial crash, it also describes the journey that must be travelled by the discipline of economics. As economics students and other commentators question post-war macro-economics, Roger Koppl provides some of the answers needed to understand the long slump after the financial crash. A theory of confidence is needed in any economic framework that is to explain one of the most important periods in modern economic history.
56 citations
Cites background or result from "Federal Reserve Policy and the Hous..."
...Taylor (2009), White (2009) and Horwitz and Boettke (2009) agree that a disproportionate fraction of the false credit created by the loose suit ended up in the housing market....
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...Thus, my interpretation is not new or original and it is influenced by interpretations given by many others including Leijonhufvud (2008), L. White (2008a, 2009), W. White (2013), Horwitz and Boettke (2009), O’Driscoll (2009), Tayor (2009), and Ravier and Lewin (2012).1 Young (2009) deserves…...
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...Taylor (2009), White (2009) and others have viewed the loose suit policy as large enough to explain the boom and why it had to end in a bust....
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...In particular, as White (2008a, 2009), Taylor (2009) and Horwitz and Boettke (2009) all note, the government-sponsored enterprises Fannie Mae and Freddie Mac actively purchased mortgage-backed securities....
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TL;DR: In this article, a self-enforcing monetary constitution has rules that agents acting within the system will uphold even in the presence of deviations from ideal knowledge and complete benevolence and thus does not require external enforcement.
Abstract: A self-enforcing monetary constitution has rules that agents acting within the system will uphold even in the presence of deviations from ideal knowledge and complete benevolence and it thus does not require external enforcement. What would such a constitution look like? Such a constitution, I show that two regimes — a version of NGDP targeting that relies on market implementation of monetary policy, and free banking — meet these requirements for self-enforcing monetary constitutions. The analysis draws insights from political economy, and from constitutional political economy in particular.
39 citations
TL;DR: In this article, the authors compare the three most prominent versions of lender-of-last-resort policy: the classical system of central bank lending on good collateral at a penalty rate, the Richmond Federal Reserve system of open market operations to prevent liquidity drains, and the New York Federal Reserve System of commitment to taking any and all action necessary to prevent the spread of financial contagion.
Abstract: Of the leading versions of lender of last resort policy, which is to be preferred in a world of realistic incentive and information imperfections? The three most prominent versions of lender of last resort policy are: the Classical system of central bank lending on good collateral at a penalty rate, the Richmond Federal Reserve system of open market operations to prevent liquidity drains, and the New York Federal Reserve system of commitment to taking any and all action necessary to prevent the spread of financial contagion. I compare these policies to the mechanisms that developed in free banking systems. Free banking systems had no formal lender of last resort, but instead developed institutions that lessened the possibility of systemic panic in the first place. I find that free banking weakly dominates the Classical system. Free banking also outperforms the New York Fed and Richmond Fed systems on the incentive margin, but is weaker on the information margin. In addition, the paper discusses how the New York Fed doctrine is the only stable activist policy, since the limited responses necessitated by the Classical and Richmond Fed policies are not credible.
37 citations
Additional excerpts
...…Horwitz and Luther (2010); Jarocinski and Smets (2012); Leamer (2007); Mehrling (2010); O’Driscoll (2012); Kling (2010); Kotlikoff (2010); Roberts (2010); Selgin, Lastrapes, and White (2010); Sumner (2011, 2012); Taylor (2007, 2009); White (2008, 2009, 2012); Woodford (2012); Woolsey (2012)....
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References
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Posted Content•
TL;DR: In this article, a counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years.
Abstract: Since the mid-1980s, monetary policy has contributed to a great moderation of the housing cycle by responding more proactively to inflation and thereby reducing the boom bust cycle. However, during the period from 2002 to 2005, the short term interest rate path deviated significantly from what this two decade experience would suggest is appropriate. A counterfactual simulation with a simple model of the housing market shows that this deviation may have been a cause of the boom and bust in housing starts and inflation in the last two years. Moreover, a significant time series correlation between housing price inflation and delinquency rates suggests that the poor credit assessments on subprime mortgages may also have been caused by this deviation.
598 citations
"Federal Reserve Policy and the Hous..." refers background in this paper
...John Taylor noted the Fed’s deviation from the Taylor Rule in his 2007 Jackson Hole Symposium paper (Taylor 2007)....
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...6 Taylor (2007) arrives at similar findings after running slightly different counterfactual simulations....
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TL;DR: This article analyzed the need for financial regulations in the implementation of central bank policy and found that financial regulations cannot readily be rationalized on the basis of macroeconomic benefits, and that financial regulation is sometimes justified on macroeconomic grounds.
Abstract: Financial deregulation is widely understood to have important economic benefits for microeconomic reasons Since Adam Smith, economists have provided arguments and evidence that unfettered private markets yield outcomes that are superior to public sector alternatives But financial regulations - specific rules and overall structures - are sometimes justified on macroeconomic grounds This paper analyzes the need for financial regulations in the implementation of central bank policy Dividing the actions of the Federal Reserve into monetary and banking policy, we find that financial regulations cannot readily be rationalized on the basis of macroeconomic benefits
347 citations
"Federal Reserve Policy and the Hous..." refers background in this paper
...By purchasing securities the central bank supports the money stock while avoiding the danger of favoritism associated with making loans to specific banks on noncompetitive terms (Goodfriend and King 1988)....
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Posted Content•
TL;DR: The authors analyzes the need for financial regulations in the implementation of central bank policy and argues that regulations are not essential for the execution of monetary policy because high-powered money can be managed with open market operations in government bonds.
Abstract: The paper analyzes the need for financial regulations in the implementation of central bank policy. It emphasizes that a central bank serves two functions. Central banks function as monetary authorities, managing high-powered money to influence the price level and real activity; and they engage in regular and emergency lending to financial institutions. The authors term these functions monetary and banking policies, respectively. They emphasize that regulations are not essential for the execution of monetary policy because high-powered money can be managed with open market operations in government bonds. By its very nature, however, banking policy involves a swap of government securities for claims on individual banks. Just as private lenders must restrict and monitor individual borrowers, a central bank must regulate and supervise the institutions that borrow from it. Virtually all economists agree that there is an important role for monetary policy to stabilize prices and real activity. Banking policy has been rationalized as a source of funds for temporarily illiquid but solvent banks. To assess that rationale, the authors develop the distinction between illiquidity and insolvency in detail, showing the distinction to be meaningful precisely because information about the value of bank assets is incomplete and costly to obtain. Nevertheless, they explain why the cost of information per se cannot rationalize banking policy. On the basis of such considerations, they find it difficult to make a case for banking policy and the regulatory and supervisory activities that support it.
231 citations
Posted Content•
TL;DR: In this paper, the authors focus on the relationship between monetary policy and the recent turmoil in the markets for housing, housing finance, and beyond, and discuss the role of monetary policy in resolving such crises and preventing future crises.
Abstract: My remarks focus on the relationship between monetary policy and the recent turmoil in the markets for housing, housing finance, and beyond. I begin with a review of the period leading up to the crisis. I then use this review as a basis for discussing the role of monetary policy in resolving such crises and preventing future crises.
150 citations
Book•
01 Jan 1997
TL;DR: Selgin explores the differences between these monetary and natural conditions, and proposes solutions of his own as discussed by the authors, concluding that persistent unemployment is a non-monetary or 'natural' economic condition, which no mount of monetary medicine can cure.
Abstract: This book sets out to explain the complexity of why increased production does not that always bring with it lower prices. According to the book, those who look upon monetary expansion as a way to eradicate almost all unemployment fail to appreciate that persistent unemployment is a non-monetary or 'natural' economic condition, which no mount of monetary medicine can cure. Selgin explores the differences between these monetary and natural conditions, and proposes solutions of his own.
138 citations
"Federal Reserve Policy and the Hous..." refers background in this paper
...Instead it should allow consumer goods prices to fall when productivity gains reduce the costs of production (see Selgin 1997)....
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