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: This paper examined how people make choices outside the assumption of "all else equal" and found that the issue is often one of asymmetric interpretation, not asymmetric information, and that people have differing interpretive frameworks.
Abstract: Although most economists model individual behavior using comparative statics, that approach ignores several important aspects of human action. How do we account for people having opposite responses to the same price change? How do changes in the market or other institutions affect what people believe and how they act? The caveat of ceteris paribus gives economists the ability to bypass problems of complex individual cognition and motivations. This paper examines how people make choices outside the assumption of "all else equal". The issue is often one of asymmetric interpretation, not asymmetric information. Many phenomena defy the logic of comparative statics because people have differing interpretive frameworks. An interpretive framework method of analysis, therefore, will give better explanations of emergent economic outcomes. For example, interpretive frameworks offer better analysis of the effects of recent Federal Reserve policy than comparative statics do. The method relies upon the costs and benefits of gaining knowledge, institutional change, and recent historical context.
7 citations
Cites background from "Federal Reserve Policy and the Hous..."
...…Neo-Keynesian (Clarida, Gali, & Gertler 1999, Mankiw 2012), Monetarist (Friedman 1968), Neo-Classical (Goodfriend 2004), and Austrian (Mises 1949, White 2009, Woods 2009, Salerno 2012) macroeconomic theories all suggest that recent monetary policy should have had more significant economic…...
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...Both shifts have reduced people's willingness to invest because they make the future performance of financial markets less certain and because the undermine confidence in the stability of the “rules of the game” (White 2009, 2010, Allison 2012, Pierce & Broughel 2012)....
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TL;DR: In this article, the authors analyzed the construction business cycle of three countries: the United States, the United Kingdom, and South Korea, and used construction industry data for categorizing GDP by economic activity.
Abstract: The construction industry is a key industry in many countries, usually making up to 5–10% of the overall gross domestic product (GDP). It is closely related to the financial and labor markets, depending on the characteristics of businesses in a given country. For example, the moratorium in Russia in 1998 and the subprime mortgage crisis in the U.S. in 2007 greatly influenced the financial markets of many countries, which consequently affected the construction market. The effect of such crises on the construction industry differs, however, depending on the size of the business cycle and the foundation of the financial market. Thus, this study analyzed the construction business cycle of three countries: the United States, the United Kingdom, and South Korea. The economies of these three countries have different characteristics. This study, which used the three-state Markov switching model, also used construction industry data for categorizing GDP by economic activity. Although the validation results...
7 citations
Additional excerpts
...financial market in 2007 (White 2009)....
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TL;DR: In this paper, the authors analyzed the U.S. housing market using Markov switching models: the Markov-switching random walk (MS-RW) model and the MS-AR model.
Abstract: Accurate projection of the economic conditions in a country can enable the government to establish appropriate policies in a timely manner. This also applies to enterprises and individuals in terms of decision-making processes, such as investing and production planning and household consumption and saving. The U.S. housing market is no exception to this practice. The prompt and accurate assess- ment of the trends in the U.S. housing market enables consumers to make quick decisions and to come up with the corresponding measures, thus minimizing risks associated with market uncertainty. The monthly indices of the U.S. housing market indicators are released at the end of the following month, creating a month-long standstill in making a judgment regarding the housing market. Consequently, it is not possible to predict the current month's market status. Therefore, in this study, various "U.S. housing market-related" indicators were calculated as aver- age month-to-month changes using the composite index methodology of the National Bureau of Economic Research (NBER). The trends in the U.S. housing market were analyzed using the Markov switching models: the Markov switching random walk (MS-RW) model and the Markov switching autoregressive (MS-AR) model. Results showed that the methods can accurately determine the trends in the U.S. housing market. Findings from the forecasting performance test made it possible to predict or forecast the prospects of the U.S. housing market within the month-long standstill period. DOI: 10.1061/(ASCE)UP.1943-5444.0000098. © 2012 American Society of Civil Engineers.
7 citations
Additional excerpts
...The recent global financial crisis may be attributed to the abnormal increase in housing prices and to extended mortgage financing (White 2009)....
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...2005; Kodrzycki and Gerew 2006; Murphy 2006; Mathur 2008), on the analysis of the government’s policies as the cause of the global financial crisis (White 2009), and on the corresponding measures being taken by related financial institutions for the prevention of future financial crises (Saxton 2008)....
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TL;DR: This article analyzed the writings and speeches of three economists, Arthur Burns, Alan Greenspan, and Ben Bernanke, as they transitioned to becoming chairmen of the Fed and found that the tension between their previously stated views and their subsequent policy stances as Fed chairmen suggest that operation within political institutions impelled them to alter their views.
7 citations
TL;DR: The enterprise risk management (ERM) framework as proposed by the COSO is used to analyse eight components of the American International Group’s (AIG) risk management system, and it is identified that issuing credit default swaps (CDSs) and investing in residential mortgage backed securities (RMBS) and commercial mortgagebacked securities (CMBS) were the direct causes of AIG”s liquidity crisis.
Abstract: In this paper we use the enterprise risk management (ERM) framework as proposed by the COSO to analyse eight components of the American International Group’s (AIG) risk management system, and then study how such a poor risk management system led to AIG’s liquidity crisis. We address two research questions in this paper: First, we examine the direct reasons for AIG’s liquidity risk in September 2008. Second, we conduct a qualitative case study to analyse how the limitations of AIG’s enterprise-wide risk management system led to its liquidity crisis. We identify that issuing credit default swaps (CDSs) and investing in residential mortgage backed securities (RMBS) and commercial mortgage backed securities (CMBS) were the direct causes of AIG’s liquidity crisis. However, the fundamental reason was AIG’s poor risk management system. Our field case study is consistent with the Erickson et al. (2000, pp.165–194) research design of first-hand and second-hand evidence for drawing inferences, and follows the prescriptions of Merchant and Van der Stede (2006, pp.117–134); and Ahrens and Chapman (2006, pp.819–841). We provide public policy and practical implications based on the conclusions of this case study.
7 citations
Cites background from "Federal Reserve Policy and the Hous..."
...According to White (2009), the Federal Reserve raised the federal funds rate in order to prevent inflation between June 2004 and June 2006....
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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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