Monetary Policy and the Saving Glut Both Mattered for the Boom

That is what Filipa Sá, Pascal Towbin, and Tomasz Wieladek find in their new paper. Moreover, they find that the effects of monetary policy and the saving glut were more pronounced in those economies with more developed and securitized mortgage markets.  On this latter point, Roger Ahrend similarly finds that easy monetary policy had its biggest effect on housing in periods of financial deregulation and innovation.  The Sá et al. paper also is consistent with the findings of Thierry Bracke and Michael Fidora who show that monetary policy shocks and global saving glut shocks contributed to the buildup of global economic imbalances.  These nuanced studies that take a global perspective and find both monetary policy and global savings to have mattered are far more satisfying than the "Not us!" research being pushed by former and current Fed officials lately.  

It would be nice, however, if these nuanced studies did more to tease out (1) how much of the saving glut was due to truly exogenous developments in the emerging economies versus (2) how much was due to endogenous responses by these economies to the Fed's loose monetary policy.  In other words, how much of the saving glut was simply recycled U.S. monetary policy? 

They Did It, They Did, They Did It!

Lately, that seems to be the message coming from current and past Fed officials regarding the housing and credit boom in the early-to-mid 2000s.  First Ben Bernanke, then Vincent Reinhart, and now Janet Yellen have come out saying it was excess savings by foreigners and failings in the U.S. private sector that was the root cause of the boom.  No blame is assigned to the Fed.  They ask how could the Fed have created a liquidity glut that drove down world interest rates and sparked off a global housing boom?

The answer is easy: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). As I showed in a recent post, there is strong evidence that a good portion of the foreign reserve buildup in the global economy during the 2000s can be tied to U.S. monetary policy.

What is amazing is that on one hand these Fed officials will acknowledge the Fed's global monetary power and then completely ignore the implications of this for early-to-mid 2000s.  I wish they wrestle with the four questions I presented to Ben Bernanke after his recent speech.   In case any of these Fed officials are interested, I am about to wrap up a coauthored paper that more fully develops the implications of the Fed's monetary superpower status during the housing boom. I would be glad to share it with them.

Update:  Here is a paper from the ECB that empirically estimates how important the global saving glut was versus monetary policy.  This is the abstract:

 Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.

One-Size-Fits-All Monetary Policy Does Not Work

Many times I have discussed here how the Eurozone is far from an optimal currency area--its member countries have different business cycles and insufficient economic shock absorbers in place--and the problems that this reality creates for the ECB in conducting monetary policy.  One of the key problems is that the ECB is applying a-one-size-fits-all monetary policy to vastly different economies.  For example, consider the case of Ireland and Germany.  When the Euro was adopted in 1999 Ireland was growing close to 10% while Germany was growing around 3%.  Should the ECB be responding to Ireland, Germany, or the average in setting its target interest  rates?  As the figure below shows, up through the end of the housing boom period Ireland was consistently growing faster than Germany. (Click on figure to enlarge.) 

Via Ralph Atkins we learn of Barclays Capital report that looks closely at this issue. Unsurprisingly, it finds the following:

ECB interest rates have generally corresponded more to economic conditions in Germany - the eurozone’s biggest economy - than the eurozone as a whole.

This means ECB monetary policy was well-suited for the low-growth German economy, but way too easy for the hot Irish economy.  Easy monetary policy, therefore, must have been an important contributor to the housing boom in Ireland during this time. I think Josh Hendrickson would agree.

The Latest Fed Smackdowns

Here are the latest critiques of Fed policy in the early-to-mid 2000s. First up is Roger Lowenstein:

[A]s it still does today, the Fed continued to concentrate on inflation in consumer goods such as cars and computers while all but ignoring speculation in investment assets.

By focusing so zealously on inflation, the Federal Reserve is essentially fighting the last war. The United States' most recent bout of serious inflation occurred in the 1970s and early '80s; in response, then-Fed Chairman Paul Volcker moved aggressively to raise rates in order to curb prices. Since then, asset bubbles have been inflating and popping ever more often.

Excesses that in the past would have produced inflation now cycle back into the economy through the financial markets.

It sounds like Lowenstein has been reading some of William White's work, maybe even his classic "Is Price Stability Enough?" My own answer to White's question is no, price stability is not enough. As I have said before, the Fed's focus should not be on stabilizing inflation but on stabilizing aggregate demand. Given current institutional arrangements, I would also like to see some form of macroprudential policies implemented as well. After all, the period of the Great Moderation was one with relatively stable aggregate demand growth but still experienced unsustainable expansions of credit and debt.

Next up is Barry Ritholtz. I am not sure what motivated this outburst today at the Big Picture, but I liked it:

I Direct Your Attention, Mr. Fed Chairman, to Exhibits 1 through 10:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

I hate having to repeat myself, but it is apparently, necessary.

Well said Barry!

Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:

[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

A Step in the Right Direction

So it seems likely that Janet Yellen will be the next Vice Chair of the Fed. I believe she is a great choice for several reasons. First, unlike Bernanke and other Fed apologists, she acknowledges U.S. monetary policy may have played a role in the housing boom:

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy. However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Second, as noted above she is open to some form of macroprudential regulation. I have become convinced by Claudio Borio, William White and others at the BIS that this is an important idea given the current realities in the financial system. Third, Yellen acknowledges that the Fed is a monetary superpower. Just admitting this point means she is taking seriously the Fed's role in creating global liquidity conditions. Any candidate who brings such fresh thinking on these three issues to the Board of Governors would be a welcome change in my view. Yes, there are areas where I disagree with her--she thinks monetary policy is limited at the zero bound, I do not--but on balance she brings a perspective to the Fed that if followed makes its less likely the Fed will repeat the monetary policy mistakes it made in the early-to-mid 2000s. Making Janet Yellen the next Vice Chair is a step in the right direction for improving the Fed.

Academic vs. Wall Street Economists

The WSJ recently asked a number of economists whether they thought the Fed's low interest rates in the early-to-mid 2000s were an important contributor to the credit and housing boom. What the WSJ found was interesting: most business and Wall Street economists (78%) answered yes while just less than half of the academic economists (48%) said yes. One way to interpret this difference is that economists who are closer to the actual financial system may sometimes see better how the low rates actually influence it. Take, for example, the difference between the academic economist Richardo Caballero and the Wall Street economist Barry Ritholtz on what drove the demand for the riskier assets during the boom. Richardo Cabaello's story is a structural one dealing with a shortage of safe assets relative to the global demand for them:

By 2001, as the demand for safe assets began to rise above what the U.S. corporate world and safe mortgage‐ borrowers naturally could provide, financial institutions began to search for mechanisms to generate triple‐A assets from previously untapped and riskier sources. Subprime borrowers were next in line, but in order to produce safe assets from their loans, “banks” had to create complex instruments and conduits that relied on the law of large numbers and tranching of their liabilities. Similar instruments were created from securitization of all sorts of payment streams, ranging from auto to student loans... Along the way, and reflecting the value associated with creating financial instruments from them, the price of real estate and other assets in short supply rose sharply. A positive feedback loop was created, as the rapid appreciation of the underlying assets seemed to justify a large triple‐A tranche for derivative CDOs and related products.

What is interesting about Cabellero's story is that there is not one mention of how incentives created by the low interest rates may have contributed to this process. Barry Ritholtz, on the other hand, sees a big role for the low interest rates in creating demand for riskier assets:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

Now Ritzholtz acknowledges regulatory failures were important as well, but the fact that he sees a role for distorted incentives created by the low federal funds rate in creating demand for riskier assets while Cabellero does not may speak to the fact that Ritzholtz is on the ground at Wall Street. Now their two views may actually complement each other. However, one is left wondering whether their differences and that between academic and Wall Street economists more generally on the importance of the Fed's low interest rates can arise based on proximity to the action in financial markets.

More on Bernanke's AEA Speech

Here are more responses to Bernanke's AEA speech where he defended the Fed's low interest rate policies in the early-to-mid 2000s:

(1) John Taylor in the WSJ
(2) John Taylor on Economics One
(3) David Papell at Econbrowser
(4) John Hilsenrath at WSJ [update: video]
(4) Mark Thoma & Vernon Smith on Economist's View
(5) Josh Hendrickson at Everyday Economist

These responses are consistent with my own thoughts on Bernanke's speech. Finally, it is worth noting that Brad DeLong acknowledges that the federal funds rate may have been too low at the time. However, he has a hard time seeing how the low interest rates could have been an important contributor to the housing boom. Let me first say I am glad that Brad DeLong is at least open to the idea that interest rates may have been too low. Second, I would encourage him to look beyond the normal monetary transmission channels in assessing how important the low federal funds rates were to the housing boom. There is obviously more to the story than just low interest rates, but one should not underestimate the effect of them in light of the risk taking channel of monetary policy.

John Cassidy on the Greenspan Put

John Cassidy shows no mercy in critiquing Bernanke's defense of the Fed's low-interest rate policies in the early-to-mid 2000s and more generally the Fed's asymmetric response to swings in asset prices:

Behind his white beard, Federal Reserve chairman Ben Bernanke has a wry sense of humour. On reading his recent speech to the American Economic Association, in which he defended the Fed’s actions during the housing bubble, I initially suspected it was a practical joke. Rather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision.

Searching in vain for a punch line, I was reminded of Talleyrand’s quip about the restored Bourbon monarchs: “They have learned nothing and forgotten nothing.” Mr Bernanke is far smarter than Louis XVIII and Charles X, two notorious boneheads, and has done a good job of firefighting. But his unwillingness to admit the Fed’s role in inflating the housing and broader credit bubble raises serious questions about his judgment.

The individual elements of his presentation were questionable enough... but most disturbing was its failure to address the larger picture: from the mid-1990s, the Fed adopted a stance that encouraged irresponsible risk-taking. In periods of growth, it raised interest rates slowly, if at all, stubbornly refusing to acknowledge the course of asset prices. But when a recession or financial blow-up beckoned, it slashed rates and acted as a lender of last resort.

On Wall Street, this asymmetric approach came to be known as “the Greenspan put”. It gave financial institutions the confidence to raise their speculative bets, using borrowed cash to do it. None of the Fed’s actions since then have addressed this central issue of moral hazard. Indeed, the problem may have become worse. For all the damage that the financial industry has inflicted on itself, when disaster arrived the Greenspan/Bernanke put did pay off. By slashing the funds rate and providing emergency credit facilities to stricken financial firms, the Fed further entrenched the perception that its ultimate role is to provide a safety net for Wall Street.

Unlike his predecessor, Mr Bernanke recognises the problem of excessive speculation and the massive externalities its sudden reversal can impose. In that sense, intellectual progress has been made. But he and his deputy, Donald Kohn, still refuse to acknowledge the Fed’s role in motivating reckless behaviour...

This is not entirely true, at least for Donald Kohn. In a November 2007 speech Kohn hints at this possibility via a comment on the Fed's role in creating the Great Moderation:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

The victim of my own success tone is slightly annoying here, but at least Kohn alludes to some of the concerns associated with the Greenspan put. Still, Cassidy's bigger point holds: the Fed has yet to fully account for its role in causing investors to underestimate aggregate risk and, as a result, make decisions that contributed to the financial crisis on 2008-2009.

A Note to Ryan Avent, Paul Krugman, and Arnold Kling

Do not underestimate the impact of the Fed's low interest rate policies in the early-to-mid 2000s. While there are many stories told as to how the low federal funds rate at this time contributed to the housing boom, one that is often overlooked but probably the most important is the "risk-taking" channel story of monetary policy. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

Tobias Adrian and Hyun Song Shin also explore this channel in their paper:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

[...]

Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. 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. 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.

Now Ritholtz acknowledges there were many factors at work during this boom. However, he makes the point, and I agree, that we have failed to learn a key lessons from this crisis if we move forward with the view that the low interest rates were of no consequence during the housing boom.

Bernanke Goes for the KO and Misses

Ben Bernanke came out swinging today throwing some hard punches at those critics who say the Fed's monetary policy was too accommodative in the early-to-mid 2000s. He does so by throwing the following four-punch combination of arguments: (1) economic conditions justified the low-interest rate policy at the time; (2) a forward looking Taylor Rule actually shows the stance of monetary policy was appropriate then; (3) there is little empirical evidence linking monetary policy and the housing boom; and (4) cross country evidence indicates the global saving glut, not monetary policy was more important to the housing boom. Though Bernanke rejects the view that interest rates were too low for too long in this speech, he does acknowledge the Fed could have been more vigilant in regulatory oversight of lending standards. By far this is one of the better defenses of the Fed's low-interest rate policy of the early-to-mid 2000s that I have seen. Arnold Kling seems convinced by this rebuttal while Mark Thoma appears more agnostic about it. While Bernanke's case seems reasonable for the 2001-2002 period, I find his arguments far from convincing on all four points for the period 2003-2005 and here is why:

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate--measured by final sales of domestic product--and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):


Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed:


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an "improved" Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule's merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down--a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap--i.e. productivity growth greatly exceeds the real interest rate--emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters):



This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the "risk-taking" channel the Fed's low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed's low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:


They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the "search for yield" created by the Fed's low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.

US vs. Canadian Monetary Policy During the Boom

James MacGee has an interesting article that compares the post-housing boom period in Canada with that of the United States (hat tip James Hamilton). Specifically, he notes that the housing bust that took place in the United States did not occur in Canada and attempts to explain this difference by looking at the two most common reasons given for the housing boom: (1) loose monetary policy and (2) relaxed lending standards. Looking at both factors, MacGee makes the following observations:

The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.

MacGee's claim that monetary policy in the two countries were similar is based on the fact that both policy interest rates followed similar paths during the housing boom (see his central bank target rate figure). Since these indicators of monetary policy did not differ much, he concludes it must be the case that the distinguishing factor between the two countries were the lax lending standards in the United States. I certainly agree that the monetary policy was not the only factor in the housing boom. I hesitate, however, to conclude that because the policy interest rates followed similar paths the stances of monetary policy were also similar. As Nick Rowe points out its not the level of the policy interest rate but where it is relative to the natural interest rate that determines the stance of monetary policy. Consequently, to make a convincing case that monetary policy was similar in Canada and the United States during this time one needs to show the difference between the natural interest rate and the policy interest rate--called the policy rate gap hereafter--for both countries followed similar paths.

So what does the policy rate gap show? It is not easy to answer this question because it requires an estimate of the natural rate of interest for both countries. I am only aware of natural interest rate estimates for the United States covering the housing boom period. Therefore, let me approximate the idea of a natural rate of interest--and will latter corroborate this approach--by looking at the growth rate of labor productivity in both countries relative to the policy interest rate. The natural interest rate, after all, is a function of individuals' time preferences, productivity, and the population growth rate. Of these three components, the one that seems to have changed the most during the housing boom in the United States was productivity. Below is a figure showing the quarterly year-on-year growth rate of labor productivity minus the ex-post real policy interest rate for both countries. (The policy rate in Canada is the overnight rate and in the United States it is the federal funds rate. The ex-post real federal funds rate is used to make a consistent comparison since I could not find quarterly inflation forecasts for Canada.) A positive gap indicates accommodative monetary policy while a negative gaps indicates tightness. (Click on the figure to enlarge it.)



This figure reveals a large policy rate gap for the United States while for Canada it shows one hovering around zero. The figure indicates, then, that monetary policy was not the same in both countries. The Canadian monetary authorities got it about right while the Fed was too accommodating. Now in case you are not convinced that this measure is truly approximating the difference between the natural interest rate and the ex-ante real policy interest rate I have constructed the actual policy rate gap measure for the United States as a comparison. The natural interest rate data comes from this paper by Fed economists John C. Williams and Thomas Laubach while the ex-ante real federal funds rate is constructed by subtracting from the federal funds rate the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters. The figure below graphs the two U.S. policy rate gap measures:



The similarity of these two series indicates the productivity-based approximation of the policy rate gap does a decent job. The low interest rates in the United States, then, appear to have been more distortionary than those in Canada.

So what is the take away from this analysis? For starters, monetary policy was an important part of the U.S. housing boom-bust cycle. Moreover, it is possible that the relaxed lending standards themselves cannot be entirely separated from this loose monetary policy. Over at Econbrowser commentator David Pearson sums it up nicely:

Weak underwriting standards and the "Greenspan Put" were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed's asymmetric monetary policy. Remember, the underwriting standards were ultimately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end...

I would also note that during the housing boom interest rates charged to non-conventional mortgages were closely tied to the federal funds rate as seen in the figure below (see this post for more on this point.)

Source: FHFA

Of course, none of this is new. John Taylor already showed us via his Taylor Rule that those countries that deviated the most from the Taylor Rule's tended to have the greatest housing booms.

Monetary Policy and the Pre-Crisis Problems in Financial Institutions

Many observers have made the case that monetary policy was too loose in the early-to-mid 2000s and, as a result, helped fuel the credit and housing boom. Some observers, however, see little role for loose monetary policy in explaining the distortions that arose in the financial system. For example, Arnold Kling's impressive paper on policies that contributed to the financial crisis finds little importance for monetary policy with regard to the bad bets and excessive leverage taken on by financial institutions during this time. While there are a number of factors that contributed to these developments in the financial system, I want to push back on the notion that monetary policy's role was relatively unimportant. There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel. Let's consider each one in turn.

I. Macroeconomic Complacency
The first point is related to the reduction of macroeconomic volatility beginning in the early 1980s that has become known as the Great Moderation. This development can be seen in the figure below which shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983.

Solid line = 10 year rolling average of real GDP growth rate
Dashed line = 1 standard deviation

Now there are many stories for this reduction in macroeconomic volatility and one of the more popular views is that the Federal Reserve (Fed) did a better job running countercyclical monetary policy. In fact, Fed Chairman Ben Bernanke made this very point in a famous 2004 speech. I think there is merit to this view, but not quite in the same way as does Bernanke. During this time one of the key ways through which the Fed was able to reduce macroeconomic volatility was by responding asymmetrically to swings in asset prices. Asset prices were allowed to soar to dizzying heights but cushioned on the way down with an easing of monetary policy (e.g. 1987 stock market crash, 1998 emerging market crisis, 2001 stock market crash). The Fed also used its powerful moral suasion ability to goad creditors into helping the distressed and systemically important LTCM hedge fund. All of these actions served to prevent problems in the financial system from affecting the real economy and thus, were probably a big factor behind the "Great Moderation" in macroeconomic activity. However, they also appear to have caused observers to underestimate aggregate risk and become complacent. This, in turn, likely contributed to the increased appetite for the debt during this time. This interpretation of events was recently alluded to by Fed Vice-Chairman Donald Kohn in a 2007 speech:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

So a macroeconomic complacency created in part by the Federal Reserve set the stage for one of the biggest credit and housing booms in modern history.

II. The Risk-Taking Channel of Monetary Policy
The risk-taking channel of monetary policy is one that looks at the relationship between the Fed's interest rate policy and risk-taking by banks. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

He goes on to empirically show a strong link between the easy monetary policy and risk-taking by banks during the early-to-mid 2000s using a database of 600 banks in the Europe and the United States. Similar work has been done by Tobias Adrian and Hyun Song Shin as I noted in this previous post. In their paper they find the following:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

I see the macroeconomic complacency idea discussed above as setting the stage for and reinforcing the risk-taking channel of monetary policy. Of course, if so then this undermines the the Sumnerian view that all was well with a 5% trend growth rate for nominal expenditures during the Great Moderation but that is another story.

The Stance of Monetary Policy Via the "Risk-Taking Channel"

There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.

Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn't been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:

We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.

While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed's low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn's work. Here are some key excerpts:

Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.

For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.

The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."[emphasis added]

His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.

No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.

I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won't repeat the same mistakes after all.

Greenspan's Cult of Personality

Alan Greenspan was a legend in his time and there was no shortage of praise for him back then. For example, who can forget Bob Woodow's 2000 book Maestro: Greenspan's Fed and the American Boom. While I was aware of this Greenspan devotion, I never realized the extent to which it rose until I read David Wessel's In Fed We Trust. In the chapter title "The Age of Delusion", Wessel directs us to a paper delivered at a major economic symposium in 2005 that had this passage in the introduction:

No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although this may come in time as the legend grows. But within the domain of monetary policy, Greenspan has been central to just about everything that has transpired in the practical world since 1987 and to some of the major developments in the academic world as well. This paper seeks to summarize and, more important, to evaluate the significance of Greenspan's impressive reign as Fed Chairman... There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System. (pp. 11-12)

This 86-page paper praising Greenspan's record epitomizes the cult of personality Greenspan had at this time and it is one reason why we got the economic debacle we are in now. Under Greenspan leadership, the Fed asymmetrically responded to swings in asset prices as they were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. While this approach probably contributed to the "Great Moderation" in macroeconomic activity it also appears to have caused observers to underestimate aggregate risk and become complacent. It is likely that it also contributed to the increased appetite for the debt during this time. These developments all helped spawn the current crisis. Greenspan's cult of personality meant little-to-no questioning of his policies.

Now not everyone bowed to emperor Greenspan. There were a few who saw his record differently. Here is one such prominent economist writing also in the year 2005 in the magazine Foreign Policy:

U.S. Federal Reserve Board Chairman Alan Greenspan is credited with simultaneously achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. But, when Greenspan steps down next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Has the world's most revered central banker unwittingly set up the global economy for disaster?

Unfortunately, this view was the exception not the rule. Let us never allow another cult of personality to develop within the Federal Reserve.

More Fed Cheerleading

The battle for the narrative of the Fed actions in the early-to-mid 2000s continues. The latest salvo comes from a blog post by David Altig of the Atlanta Fed and a Cato Policy Analysis piece by Jagadeesh Gokhale and Peter Van Doren. In both cases the authors absolve the Fed of any wronging doing during the housing boom period. I am not surprised to see Fed cheerleading coming from a Fed insider, but from the CATO institute? These are strange times.

In the first article, Altig conveniently finds a modified form of the Taylor Rule that shows the Fed acted no differently than it had in past 20+ years when monetary policy seemingly worked fine. The first problem with this piece is the obvious problem of data-mining a modified Taylor Rule that justifies ex-post his employers actions. If Altig really wants to be convincing, he needs to explain why the original Taylor Rule, which does show the Fed being unusually accommodative during the housing boom, is suspect and why his modified Taylor Rule is better. As John Taylor has shown, the original Taylor rule goes a long way in explaining this crisis. For example, Taylor shows in the figure below that deviations from the Taylor rule in Europe were closely associated with changes in residential investments during the housing boom there (click on figure to enlarge):


Even if Altig could show that his modified Taylor rule makes more sense, there is still the question of whether monetary policy was truly optimal during the previous 20+ years to the housing boom. This was the period of the Great Moderation--a time of reduced macroeconomic volatility--whose appearance has been attributed, in part, to improved monetary policy. As many observers have noted, though, this also was a period of the Fed asymmetrically responding to swings in asset prices. Asset prices were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. This behavior by the Fed appears in retrospect to have caused observers to underestimate aggregate risk and become complacent. It also probably contributed to the increased appetite for the debt during this time. To the extent these developments were part of the reason for the decline in macroeconomic volatility, the Great Moderation and the monetary policy behind it becomes less of a success story.

In the second article Gokhale and Van Doren make the following arguments: (1) detecting asset bubbles is a difficult thing to do; (2) even if the Fed could have detected and popped the asset bubble in the housing market in the early-to-mid 2000s it would have done so at the expense of a painful deflation; and (3) the Fed's ability to reign in home prices was limited. On (1) I agree that responding to an asset bubble after it has formed is challenging. But that is not the the point of most observers who find fault with the Fed during this time. They would say the Fed could have prevented the housing boom from emerging in the first place had monetary policy started tightening before June 2004. On (2) the authors still think the deflationary pressures of that time were the result of a weakened economy. This is simply not the case. As I just recently noted on this blog (here and here), rapid productivity gains were the source of the deflationary pressures, not declining aggregate demand. In fact, by 2003 nominal spending was soaring at a rapid pace. In other words, the deflationary pressures of 2003 were vastly different than the deflationary pressures of 2009. On (3) the authors claim that there was simply no way for the Fed to reign in home prices since the influence of its target federal funds rate on other interest rates declined during the time of the housing boom. While it is true the link between monetary policy and long-term interest rates is more tenuous, the authors argue that even interest rates on ARMs and other subprime-type mortgages were beyond the Fed's influence. A CATO Policy Briefing by Lawrence H. White, however, provides evidence that the supbrime market was in fact very sensitive to the Fed's action during this time. Below is figure that corroborates White's work by showing the effective interest rates on ARM mortgages along with the federal funds rate. Is there any doubt? (Click on figure to enlarge):

Update: To support my claim that nominal spending was soaring by 2003 I have posted a figure below that shows the growth rate of domestic demand relative to the federal funds rate since 2002. The years 2003 to 2004 are marked off by the dashed lines. Note that the growth rate of nominal spending is increasing during the 2003-2004 period while interest rates are kept low for most of the period (click on figure to enlarge):

How Well Known Was the Productivty Surge of the Early 2000s?

In my previous post I noted that the rebound in productivity growth that started in the 1990s did not end with the tech bubble bursting in 2000. Rather, it took a temporary respite and then continued to accelerate for a few more years. The point of my sharing this information is that the robust productivity gains of the early-to-mid 2000s imply interest rates should have been higher. Instead they were dropping, a sign that monetary policy was too loose. This development also sheds light on the origins of the deflation scare of 2003: inflation was falling because of positive aggregate supply shocks (i.e. the rapid productivity gains) not negative aggregate demand shocks as was believed back then. Nominal spending, in fact, was soaring during this period. Consequently, the U.S. economy was getting juiced-up on easy money at same time it was being buffeted with positive productivity shocks. This policy response primed the U.S. economy for the emergence of economic imbalances.

A few commentators objected to this interpretation of events. They conceded that the actual productivity growth rate may have continued to surge, but questioned whether productivity expectations kept up with reality. Instead, they surmised that expectations of productivity growth declined after the tech bubble burst. If so, the expected marginal product of capital would have declined, investment demand would have decreased, and the neutral rate of interest also would have fallen. This is a great objection and one I had to check out. First, I went to the Survey of Economic Forecasters from the Philadelphia Fed and looked at the forecast of the average productivity growth rate over the next 10 years. This series begins in 1992 and is graphed below (click on figure to enlarge):


This figure show that the 10-year productivity forecast decline slightly in 2002 but resumed its climb in 2003. It peaks out in 2004, with mild declines in 2005 and 2006. By 2007 the writing was on the wall and the forecast begins to rapidly decline. This figure suggest, then, the actual productivity gains during this time were known and shaping the long-term forecast of productivity growth.

As a robustness check--and because I vaguely remembered there being a lot productivity stories in the media back in 2003-2004--I went to Lexus-Nexus and did a U.S. newspaper and news wire search with the following key words: productivity growth, accelerated or increased or pick up or faster or miracle or upward or improved or strong or robust or sustained. This search was intended to pick up articles, if any, discussing the productivity surge at the time. Here is what I found over 1992-2009 (click on figure to enlarge):

This figure shows a similar pattern: news stories on positive productivity growth articles temporarily declined in 2001 but then continued their upward momentum thereafter. The series peaks in 2005 and then begins a dramatic collapse. The positive productivity news stories bubble pops at that time.

The above figures may not convince everyone, but they are enough evidence for me to conclude that my earlier interpretation of events during the early-to-mid 2000s cannot be too far off the mark.

Critically Assessing Bernanke's Record

Now that Bernanke has been renominated to lead U.S. monetary policy his time at the Fed is being critically assessed by a number of observers. Here are five assessments:

(1) Simon Johnson says there are multiple versions of Bernanke--the one that saved the financial system after the Lehman-AIG collapse, the one that intellectually justified Greenspan's low interest rate policy and indifference to asset bubbles, and the one that has pushed for reform of the financial system--and would like to know which one we are going to get in his second term. He also is resigned to the fact that the current Fed policies will most likely lead to another bubble and financial crash.

(2) Stephen Roach highlights three critical mistakes Bernanke made: (i) he saw no need for the Fed to preempt asset bubbles, (ii) he was the intellectual architect of the saving glut view that allowed the Fed to turn the other way when housing boom was taking off, and (iii) he failed to take seriously the need to get a handle on the seriousness of the derivative explosion, the shadow banking system, and the extent of leverage in the U.S. economy.

(3) Ambrose Evans-Pritchard notes that it was Bernanke who provided "academic cover" for (i) Greenspan's view that asset bubbles do not matter and for (ii) holding down interest rates for so long below their neutral level.

(4) Desmond Lachman believes Bernanke's heroic efforts over the past nine months must not overshadow the indifference Bernanke's Fed had toward the housing boom in 2006 and 2007 leading up to the crisis nor his role in the Lehman debacle.

(5) Barry Ritholtz acknowledges that Bernanke's endorsement of Greenspan's interest rate policies were problematic and that his views on asset bubbles and the saving glut gave credence to the Fed's indifference to the housing boom. However, Ritholtz ultimately holds Greenspan accountable for the policies of that time.