Who’s to Blame?
There has been a rash of speeches, articles, and op-ed pieces exploring the origins of the housing bubble and trying to place the blame on the actions of the Federal Reserve. Some of these efforts are honorable – recognizing that we have a responsibility to understand what when wrong and how to avoid repeating those mistakes. Other criticism has more political roots.
As a quick review for my students – Our most recent and serious recession came about largely because the prices of real estate and houses accelerated dramatically, and out of proportion to other purchases or investments that the average American could make. When that bubble of high prices popped, financial institutions which had been lulled into thinking their real estate-related investments were safe, found their balance sheets decimated. This has happened several times before in our country’s history, including the technology stock bubble in the late 1990s and 2000, and as far back as the 1800s for railroad properties and precious metals. Even in the 17th century speculation in tulip bulbs caused an economic collapse.
There are two main criticisms about Federal Reserve actions in the last 3-4 years:
- The Federal Reserve kept short term interest rates too low, for too long a time following the mild recession in 2001. Critics argue that this monetary policy encouraged risky borrowing and unnaturally inflated housing prices.
- The Federal Reserve was lax in its oversight and regulation of the financial services sector – both over institutions, like banks, and over the risky mortgage lending practices. Regulatory faith in the power of market mechanisms was unearned, and institutions made what we now see as irrational moves.
At a meeting of the American Economic Association in Atlanta this week, Chm. Bernanke rejected the idea that monetary policy caused the housing bubble, but he did acknowledge that weakness in regulatory efforts played a major role.
U of Oregon professor, Mark Thoma, has a nice piece on these issues:
I have been more defensive of the Fed’s actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.
I’ve gotten on this soapbox before – though the Federal Reserve is a human, fallible organization it is staffed and led by thoughtful professionals and should continue to be protected from political second guessing. There is no member of Congress, including Rep. Barney Frank, who can bring more intellectual and effective knowledge to bear on this issue than Bernanke and his staff.
I teach principles of economics courses and a course in the economics of healthcare at Southern Oregon University.
I’m going to disagree with you on this one in a rather significant way.
First of all, the Fed has an ideological bent that has massive consequences on the people of this country. Alan Greenspan’s inability to see past his belief in the world as described by Ayn Rand nearly ran our economy off of a cliff. At the end of it all, saying, “Oops, I’m fallible” doesn’t quite wash with me. Economists should no longer be given the luxury of power without the responsibility of accountability.
If a doctor makes an error in judgment, a person could die. If an economist does, millions could suffer or die. We don’t even have to take an oath. So, yes, I think political oversight (what you might call second-guessing if you were inclined to poison the well) is justified.
Bernanke’s statements are disconcerting to me. Allow me to explain why:
According to the Case-Schiller Index (which indexed at 2000), housing prices increased to 146% (of the 2000 index – “I”) by 2004, peaking at 189% I in 2006. So, can we explain that through normal market action?
The main demand drivers for housing are two: population and household income.
The primary supply driver is the housing stock.
If we just look between 2000 and 2004, population growth was around 1.5%, while income per capita declined by 3%, creating an average income per household decline of 1.4%. (Source: New York Times) These aren’t major shifts, but should have resulted in an overall lessening of demand (the total money chasing the market declined).
According to the normal model, then, supply must have been decreasing substantially to suggest such a massive increase in price, right?
In 2000 we had ~115 million units of housing. The rate at which new units were being added to the market changes from ~1.5 mil homes/year (in 2000 – 2001) to ~2.2 mil homes/year (2004 – 2005). So, while apparent demand was being driven down, supply was being driven up. But prices were increasing. This seems to imply that either economics stopped working or that there’s something big influencing the market, right?
At this point one might suggest someone should have noticed this complete reversal of normal market behavior in 2004 – but it’s easy to point fingers after the fact, so I digress.
The most likely explanation for this seems to be that demand was going up because financing was getting easier. Lending standards kept declining, allowing more and more people to take on more and more debt. Bernanke chocks this up to a lack of regulation. This is true, but it’s not the whole story – and I don’t think it’s fair to stop there.
Prior to this time period the Fed was lowering interest rates substantially under Greenspan, and as a result t-bill prices reached all-time lows. This had two major effects:
First: Banks could easily borrow from the Fed, allowing them to lever up into profitable markets.
Second: Asian surpluses and U.S. investors, turned off by low yields on t-bills (1%), start looking to Wall Street for good returns.
Taken together, these two things meant that Wall Street was being given massive incentives to take big risks while looking the other way. The Gordon Gecko’s came out of the woodwork because we started rewarding them.
So, Yes, investors were pressuring banks to find newer ways to invest their money. Yes, banks were taking risks and making more and more opaque financial products, leveraging themselves 30 to 1. But these are direct, measurable results of the Fed’s monetary policies, not unrelated happenings.
Maybe I’m not qualified to make this statement (and please correct me if I am blatantly wrong) but it seems completely ludicrous for anyone (even Bernanke) to argue that monetary policy was not the primary driver of the housing bubble.
Just one quick note to Paul’s thoughtful critique. Bernanke doesn’t dismiss the housing bubble, but claims that it was due more to inflows of capital funds from foreign sources. I saw a portion of his speech to the AEA (gotta find the full version somewhere) that had an academic bent to it, showing possible correlations of monetary policy and inflows against housing prices. In is mind the capital inflows were a bigger part of the explanation.