Liquidity Trap

Was it Popeye’s friend, Wimpy, who kept asking for a hamburger on credit? Today’s credit markets are anything but robust, with reduced demand and supply for borrowed funds. Always eager to find obscure terms for modern dilemmas, economists refer to this condition as a liquidity trap. With a little prodding from Facebook friend and neighbor, Patrick, we’ll give the concept a once over.

Jumping to the conclusion (and resisting the academic approach of a slow, careful warm-up) there is bad news and good news about liquidity traps. The bad news is that they make it difficult for the Federal Reserve to execute monetary policy. Creating 100s of billions of dollars has a muted impact on our economic recovery. The good news is that the liquidity trap dampens the significant inflation we might expect with the creation of all that money.

OK, back to the beginning. During times of slow or no growth and high unemployment the Federal Reserve can create/inject money, largely by increasing reserves that banks have in their accounts with the Fed. They can do this by buying U.S. treasury bonds on the open market, or even by buying troubled/toxic assets from banks. This increase in the supply of money allows interest rates to fall, which in term spurs demand for more consumption and investment. This is classic monetary policy. With mild downturns this is often enough to increase growth and kick start the economy. For the most recent 2007-2009 recession the Fed took these actions, a number of times in a number of ways, and those actions were not sufficient. Now the target short term interest rate – the Fed Funds rate – is essentially at zero. The Fed can’t lower the interest rates any further. Here’s a graph of the Fed Funds rate since 1980. The big peak at the beginning of the graph was the result of aggressive Fed action to contain inflation. Now, though, the rate has sunk to the very floor.

Fed Funds Rate - St. Louis FRED database

One thing that is happening is that while reserves are building up in our financial system, the banks are holding on to them rather than increasing their lending. Some argue that the banks are using the added funds to improve their balance sheets, which were hurt by the dramatic loss in value of securitized mortgages and other derivative assets, and to build up enough cash to pay executive bonuses. The banks argue that demand for credit by qualified borrowers is low. I don’t put much credence in the latter explanation.  One apt analogy for this situation is that the Fed is trying to push on the end of a string, in order to get the economy going.

There is another layer to the liquidity trap concept, and that has to do with the buying public’s (people and business) expectation for inflation. The theory goes that if buyers expect inflation in the future, they will increase buying now. They expect the value of their cash or savings to go down during inflationary times, so they seek to use it now, while its value is still high. This works with traditional monetary policy where an injection of money would be expected to increase inflationary pressures.

On the other hand if purchasers believe that inflation will be controlled, then there is less pressure to buy now. That’s what is happening now. Despite what some politicians suggest, inflation is not right around the corner, and buyers are in no hurry to convert their cash into goods. We see evidence of this with the continuing low interest rates on U.S. bonds. Expectations of high inflation would push those interest rates up. Low inflation expectations, even in the face of increasing money supply is another symptom of a liquidity trap.

This scenario played out, to grim effect, in Japan in the 1990s, as their central bank poured money into the banking system and no one responded. Their “lost decade” was one of almost zero growth.

This paper by a New York Federal Reserve staff economist explains things in more detail, complete with impenetrable equations.

In his Nobel Prize speech this past Thursday, 2011 laureate Thomas Sargent made a very interesting link between the multi-country crisis in Europe and a similar situation in America’s infancy, bringing together 13 independent states. The speech itself is oddly uninspiring, and starts with some of the math for which Sargent was recognized in being award the Nobel Prize, but you can watch it here for extra gems I may have missed.

Original 13 States

Sargent noted that the new American country faced an economic crisis in the late 1780s. The first U.S. Constitution, the Articles of Confederation, left the original 13 states largely independent, with a weak, and poor Federal Government. The states and the Federal government had collective debts totaling over 40% of GDP. The 14 different governments found that investors were very skeptical of government bonds, which meant very high interest rates, and those bonds being sold in the secondary market for deep discounts. (Jump forward to 2011 to a nearly identical problem faced by the European countries.) Sargent’s observation; “Fiscal crises often produce political revolution.” This was apparent in 1787 as the United States lurched into an uncertain future.

Alexander Hamilton

Alexander Hamilton, a 32 year old Secretary of the Treasury, joined President Washington and other founding fathers in framing a new, more permanent U.S. Constitution. As part of this legal realignment, Hamilton proposed a solution to these lingering, expensive debts:

• The Federal government would assume all of the states’ debts (i.e. a bailout.)
• All trade and most fiscal policies would be centralized in the Federal government.
• The Federal government would have an enhanced ability to tax.
• There was essentially no monetary policy at the moment. The U.S. minted a silver dollar – similar to other silver pieces minted in Europe. Its value was tied to the value of silver. In essence the U.S. was on a silver standard for the first decades of its existence.

Sargent noted the results of Hamilton’s moves:

• The creditors, who held the old bonds, were kept whole and rewarded the new Federal government with more lending capacity.
• The government bonds were no longer sold at a discount, and interest rates fell to manageable levels.
• There was increased liquidity – i.e. improved availability of credit for businesses and government
• The Federal government enjoyed significantly greater tax revenues.
• Not right away, but eventually the Federal government signaled that it would no longer bail out state or local governments for their debts, and in quick succession, states passed balanced budget amendments to their state constitutions.

For history buffs, Hamilton’s first report to Congress, on public credit is an interesting read.

Europe

Now, let’s make the links to the European debt crisis. For a variety of reasons many European governments are faced with the same challenges as the fledging United States in the 1780s. Some countries, most notably Greece, mismanaged their fiscal policies, with generous government spending and lackluster tax collection. Some countries rode the surf wave of the financial bubble, allowing local banks and sometimes sovereign funds to speculate heavily. (Ireland comes to mind here.) Others, like Spain, are almost innocent bystanders with modest debt but heavily hit by the housing/credit crisis. All of these countries face investor skepticism towards their sovereign debt, which means they need to pay high interest rates if anyone is interested in buying their bonds.

As we have discussed in an earlier post, the countries who share the Euro currency have no independent monetary policy. That power is held by the European Central Bank which has been reluctant to be a lender of last resort or the source of monetary stimulus. Germany, as the strongest economy on the continent, and to some extent France, have struggled with the question of bailouts to troubled countries, maintenance of the Eurozone community, and their own political concerns at home.

Angela Merkel

In a marathon negotiating session this past week, German Chancellor Angela Merkel drove a resolution to this crisis which involves greater fiscal policy discipline and coordination among the European countries, and the strengthening of a multi-national lending fund to help struggling countries. As an interesting side note Great Britain, which has been a party of past European treaties but did not join the Euro currency, rejected the new treaty and will be on its own.

In his Noble speech, Sargent left the conclusions to his audience. Are we seeing Europe following the path of the original 13 states of the U.S. in the formation of a much more centralized Europe? Will the global investment community reward this action with lower interest rates on European debt? Will the member countries change their behavior, with the example of bailouts fresh in their memory?

Greece Flag

So, who cares about the Greek debt crisis? It’s a small country, a long ways away.

Answers:

Greece as a Country: “We care!”

The Euro currency countries: “We care!”

Europe Generally: “We care!”

U.S. and International Financial Community: “We care!”

Stock Investors: “We care!”

All right, already.  Here’s why they care.

The background

Through a series of missteps over the last 10 years the Greece government amassed a large government (or sovereign) debt, and then disguised it from its citizens, lending institutions, its Euro partners, and international financial organizations. The recession exacerbated the problem, threatening to push the Greece government into bankruptcy. Annual deficits as a percent of GDP or total national debt as a percent of GDP are higher but not that different from the United States, but in contrast to the U.S. the global investment community has very little confidence in Greek bonds and the ability of the government to repay them. That means Greece has to pay much higher interest rates on its debt, if it can borrow money at all.

What Can Greece Do?

When faced with larger government deficits, policy makers typically turn to two economic “levers” – fiscal policy and monetary policy. On the fiscal side the government can cut spending and/or raise taxes. Both of these actions have met strong resistance in a country used to heavy subsidies of middle class citizens and notoriously poor tax collection records.

Monetary policy can be an effective tool – often because it does not require the approval of the legislature or the voters. Normally a central bank can inject funds into the economy (electronically “printing” money) and use that to pay debts. This injection of money can also lead to the devaluation of the local currency. While devaluing doesn’t sound appetizing it can be very effective, since it encourages more exports and more tax revenues, and because it makes it easier to pay off debts denominated in the local currency.

BUT, Greece can’t execute its own monetary policy. It is a member of the Eurozone – using the Euro as its currency rather than the drachma. As a result Greece cannot unilaterally change the supply of its currency. It does not have control over monetary policy. To make matters worse for Greece, the Euro has held a fairly high value against other world currencies – just opposite of the direction Greece needs to help with its problems.

Euro

How Does the Crisis Affect the Euro?

The Euro is a common currency, currently used by 22 European countries. Decisions on the supply of the Euro are made by a representative body at the European Central Bank.

When a member country, like Greece, threatens to default on its loans, global investors pull funds out of Greece and the Eurozone. This reduces the demand for euros, and causes the value of the euro to fall. This is a mixed blessing. Countries often prefer a strong currency, but a weaker one can encourage exports. Europe is an export driven continent.

Joining the Eurozone initially, countries have to prove that their economies and government budgets are healthy. It is like welcoming someone new onto a lifeboat. You prefer the new person to be healthy. It appears that Greece hid or obscured its economic reports when applying for membership and now its fellow lifeboat members are not happy.

Commentators, such as Paul Krugman, have argued that Greece should never have been allowed in the Eurozone. They also argue that the Euro common currency is flawed if monetary policy is directed centrally, but fiscal policy remains with individual countries. Macroeconomic theory suggests that both need to work in concert, and the slow, deliberative and political style of the European Central Bank is not well suited to crisis management. Here’s one of many Krugman posts on the crisis.

Why the Large Bailouts by European Governments?

Other European countries, particularly those who share the use of the euro currency, want to stabilize the currency in their own self-interest. In addition many of the large banks and financial institutions in Europe hold Greek debt. If Greece defaults on that debt, those institutions are in trouble. France and Germany have been two of the largest contributors. French voters have been relatively quiet about the bailout, but German politics are much more sensitive to the issue. Chancellor Merkel of Germany has to balance the need to preserve the Eurozone economy against the indignation of German taxpayers who feel little affection for Greece.

European policymakers also worry about other members of the Eurozone – including Spain and Ireland. These two countries have stressed economies for reasons different than Greece. Neither of them had profligate government spending, but both have been hit particularly hard by the recession. Additional stresses on Europe could tip these countries further into trouble.

Why the International Community and Stock Investors Worry

The source of concern in the stock markets and among international investors is mostly fear of default. Large financial institutions and other holders of Greek debt would be seriously hurt. If a Greek default pushed other European countries like Spain and Ireland over, the impact grows significantly.

The modest inflation measures will change in the future. We almost certainly should expect prices to rise more rapidly. We just don’t know when, or for how long.

Aggregate Demand and Aggregate Supply

This blog post by economist Tim Duy has a very thorough and clear explanation of some of the forces gathering on the inflationary front. He presents this as a way to help understand the decisions and debate within the Federal Open Market Committee (FOMC) in the months to come. Though clear, his explanation requires an understanding of aggregate demand and aggregate supply curves. So, for my students, mark this post and come back to it once we’ve covered those subjects.

For any reader, here are the summary conclusions that Duy reaches:

We can track the path of the prices and output and explore the positions of Fed officials within a fairly simple framework.  That framework suggests that the economy will experience a temporary period of accelerating inflation as it returns to potential (we should be so lucky, quite frankly).  There doesn’t seem to be much debate at what speed this will occur; Fed officials appear comfortable with growth expectations around 3.7% this year.  What does seem to be an issue of debate is the size of the unemployment gap.  If we are close to the natural rate of output, excess monetary stimulus is close to triggering the fabled wage-price spiral.  If far away, there is plenty of excess capacity and thus no need to tighten quickly.  Indeed, tightening policy too soon would only entrench disinflationary expectations.  Fed officials appear to be splitting along these two basic views of the world, with one side seeing recent price increases as consistent with their inflationary nightmares.  I tend toward the other, which I also think will be the dominate view at the FOMC.

And here is my translation:

• The Fed expects economic growth to continue, and even at a somewhat faster pace.
• Our regular models suggest that this continued growth will put upward pressure on prices.
• One big unknown is whether there is a lot of unused capacity in our economy – particularly among workers.
• If there are a lot of workers who can be put back into production, without much training, we have plenty of unused capacity which will soften inflation.
• If those workers who are still unemployed have the wrong skills or geographic location, our unused capacity is smaller.
• As we use up our capacity and get closer to full economic production, we get closer to the danger of a wage-price spiral that would cause inflation to increase significantly.
• Some members of the FOMC fear we are close to capacity and that any more moves to stimulate the economy will trigger that wage-price spiral.
• Other members of the FOMC are less worried about inflation and instead fear that a cutback in stimulus efforts will stall the recover.
• Duy predicts that the inflation hawks (the first group) will be outvoted by those worried about recovery.

For my students – this is a bit more complicated than we handle in a Principles class, but a good way to test your understanding of aggregate demand and aggregate supply.

From the web site:

Prologue.

Ira Glass speaks with several members of the Planet Money team, who all found themselves—in the course of their reporting—independently asking the same stoner-ish question: What is money? Ira and Planet Money producer Jacob Goldstein discuss a pre-industrial society on the island of Yap that used giant stones as currency.

Act One. The Lie That Saved Brazil.

A trip to a country where the fiction that is money completely fell apart. And in this same country, through a truly incredible piece of policy making, the government tricked a 150,000,000 people into believing their money had value again. Chana Joffe-Walt reports. (16 minutes)

Act Two. Weekend At Bernanke’s.

Though the name of the Federal Reserve includes the word “federal,” it’s not actually part of the government. It’s an independent institution tasked with something very simple, but very huge: Creating money out of thin air. And during this last financial crisis, the leaders of the Fed did things that they would never have considered doing in the past. Alex Blumberg and David Kestenbaum report on what the Fed usually does, and how, since 2008, it’s taken a trip to what amounts to Fed Crazytown. (26 minutes)

Photo courtesy of BullionVault on Flickr.com

The price of gold has gone over $1,400 an ounce recently. In addition to the raft of stories and questions about investing in gold, I get questions about whether we should return to the gold standard. Blogger confession – I’m going to use the opportunity to organize my own thoughts on the issue.

The quick answer comes from John Maynard Keynes (written in 1924) “In truth, the gold standard is already a barbarous relic.”  I lack Keynes’ vivid parsimony, so it will take many more words for me to explain why I agree with him.

First, a general definition. When we talk about monetary policy and the gold standard we mean that a country promises to keep a stable relationship between gold and the country’s currency. This often has two consequences. First, the country needs to hold/own enough gold in proportion to the money in circulation. This proportion need not be 100%. During the period between World War I and the Great Depression economically healthy countries had enough gold to represent about 40% of the currency in circulation. Whatever the proportion, a country on the gold standard is obliged to ease or constrain credit to keep the value of currency in circulation in line with gold reserves. No gold – no economic growth.

The second consequence is that the government often needs to promise to redeem its currency for gold, at a price within an established range. This promise reinforces the government’s commitment to a stable currency value.

Many (most?) industrial governments  sought to stay on the gold standard during the first half of the 20th century. The three major exceptions were during the two world wars and during the Great Depression. The wartime pressures on government spending usually required the creation of more money and easier credit. and governments had to set aside the promises inherent in the gold standard. The Depression had similar and additional pressures.  Towards the end of WWII the Allies met and agreed on a stable international currency system, focused on the U.S. dollar, with the U.S. government also committing to maintaining a stable relationship, in terms of value, between the dollar and gold. This agreement lasted from 1944 until 1973. Since 1973 the U.S. currency, and most other first world currencies have floated in value and are not linked to gold.

One interesting conclusion reached by researchers, including Ben Bernanke when he was an academic, was that nations that stayed on the gold standard longer in the early part of the Depression had slower recoveries. Those nations that abandoned the constraints of the gold standard recovered more quickly.

Gold bugs are people who advocate for a return to the gold standard. Actually, originally (and more correctly) the term referred to investors who were bullish on gold. They prefer that money creation by the central bank (Federal Reserve in the case of the United States) be limited to the amount of gold reserves held by the country. They also prefer the implicit global currency exchange stability that could occur if our trading partners were also on the gold standard. Sticking with gold would constrain economic growth – limited by the discovery and availability of this precious metal.

Their faith in the gold standard is misplaced. There are numerous times when central bankers, with the support of their governments, have abandoned the standard under stressful conditions. The strength of a limited standard is based on everyone believing that the standard will prevail permanently. Unfortunately, political history doesn’t give us any confidence that we could stick to a standard indefinitely, and the markets and businesses will be quick to spot any weakening in resolve. Once that happens, a spiral of inflation expectations, accompanied by reduced investments, will cripple economies.

To grossly over-simplify Keynes’ objections to the gold standard – he wanted governments to have flexibility to react to adverse economic conditions, easing or tightening credit, influencing the value of their currency, and building or reducing debt. He argued that temporary fixes were necessary, and that remedial action after the crisis was also necessary. Strict adherence to a gold standard removes the flexibility he wanted.

There are dangers in letting a central bank print/create money with abandon; this invites dangerous inflation. It is crucial that central bankers have a plan in place to reduce the money supply when the economic crisis is over, and to do it in a way that allows the economy to anticipate and adjust. Adopting a gold standard doesn’t automatically make central bankers and politicians wise. It is a flimsy framework and no replacement for thoughtful monetary policy.

As we all know, the European Union has recently been under the lime light with their budget deficit problem – causing a lot of anxiety for investors in the U.S. I’m curious if there’s a reason why the even greater deficit in U.S. isn’t being publicized as much?

Crumbling Parthenon

The quick and honest answer is that I don’t have any special insights into the minds and souls of investors – not being one myself. Still, there are some characteristics of the European economic crisis that are different from the United States, but can provide cautionary tales for our own economic policy.

As of today the US national debt stands at $12,988 billion (that’s almost $13 trillion). In 2009 our Gross Domestic Product was $14,256 billion. So our debt is about 91% of GDP.  From news sources Greece has debt of around $368 billion, and a 2009 GDP of $357 billion – a debt load of 103%. So somewhat higher than the US but not by multiples.

So, just to repeat my earlier disclaimer – I don’t know what makes international investors tick. Here, though, are some of my concerns about Greece and Europe, and what distinguishes them from the U.S.

Greece is a member of the Euro community – i.e. they no longer have their own currency, but use the Euro instead. This should provide stability in foreign exchange markets, compared with maintaining their own currency. On the other hand, Greece no longer has sovereign control over its own monetary policy. The Euro central bank can change the supply of euros, and the Euro community in general impacts the value of the euro on the foreign exchange market. In sort Greece is dependent on others to apply some traditional rescue strategies. What Greece has in common with the United States is the need to balance government revenues and government expenses in the long run.

The concern about Greece seems to be bigger than Greece. Policy makers and observers worry about other country members of the euro community, including Spain and Portugal. They see a domino effect that threatens most of Europe. For the U.S. that means worrying about some of our best customers and understanding that the global financial structure is interdependent, with a credit crisis in Europe spreading here quickly.

I also think confidence in the central banking and political system plays a role in investor perception. We’re quick to criticize both the Federal Reserve and Congress for their actions or inactions. The world has a more sanguine view of these institutions, though. The value of the U.S. dollar has been rising in recent weeks, as investors switch to dollar-denominated securities – in particular U.S. treasury bonds. Those investors have more confidence in the U.S. than in Europe – for better or for worse.

None of this means that the U.S. debt situation is nothing to worry about. While I may not be confident in the economic policy process in Congress, I do have faith in the Federal Reserve. And in contrast to the deficit hawks I believe we still need to be spending government money to stimulate our recovery.

Now comes the incredibly difficult climb out of the recession trough. We’ve started climbing, with two successive quarters of positive real GDP growth. The newspapers, cable, talk shows, and blogosphere are filled with opinions, warnings, and predictions. I’m in no position to give a complete prescription for future economic policy, but this is an excellent time for students to be thinking through the issues. They need to separate out the fundamental building blocks of a strong economy and push aside alarmist claims.  Here’s a list of things to think about:

1. Monetary policy and the Federal Reserve: In a mild recession the Fed is our policy instrument of choice. They loosen the money supply, which in turn lowers interests rates a bit, which in turn  helps consumers buy goods and businesses to invest in the future. In the recession that started December 2007, the Fed started with this response but the depth and seriousness of the downturn outstripped the ability of routine monetary policy. They then turned to extraordinary steps to provide stability and liquidity in the financial markets, and have worked to maintain a banking system that will receive deposits from trusting depositors and make loans to worthwhile borrowers. To do this they pumped billions (over a trillion) of dollars into our system.They are now focused on how to retrieve that excess money, so that a more active economy doesn’t use it to spur inflation. They’ve been thinking about this a lot, and Chairman Bernanke insists they will be able to gradually reverse the steps they took, without sending the economy in a tailspin. The Fed also has to decide when to reverse the “normal” monetary policy and started pushing interest rates up. As I see it they are working in kind of a LIFO (last in; first out) order. The most serious and unusual interventions will be corrected first, and then the milder interest rate policies will be corrected as the economy approaches a more normal course.
2. Fiscal Policy and the Congress and Administration: Congress correctly passed a large stimulus spending bill over a year ago. The economy  needed it; routine monetary policy was not going to be sufficient to end the recession; and it would have been political suicide not to take action. The stimulus bill was not perfect. It was probably not large enough. It had some favorite son policy objectives that hindered speedy impact of the spending on the economy, and it had some not very effective tax cuts in order to garner bipartisan support.I’ve learned to appreciate a “prime the pump” analogy for fiscal policy actions like this. If you’ve ever had to use a hand pump you know that sometimes you have to add water in the top in order to get the process working. Government stimulus funds are like priming the pump. They immediately add something to the GDP, since government spending is one component of GDP. The real test of a fiscal stimulus is whether the priming works. In an ideal case, the initial injection of spending prompts a cascading series of new spending decisions in the private sector. This is the essence of what my students learn as the multiplier effect. New spending on roads means more wages for road workers, who hopefully become more likely to spend, and the establishments where those workers spend have the same opportunity. There are plenty of signs that the initial stimulus money started improving GDP. Whether that money has successfully primed the pump is an open question. Some policy experts are calling for more stimulus – a second priming. Others (not including those who object on philosophical grounds to more government spending) worry that another fiscal stimulus would boost the economy just as it is getting better on its own, and could spark an inflationary spiral.There has been a flurry of “job bills” discussed by the administration and Congress. Many of these are responses to a perceived (probably real) concern among the American voter that jobs aren’t coming back quickly enough and something needs to be done about it. I don’t know enough about them to comment thoughtfully. Based on past performance it is easy to guess that some proposals will do little to make a permanent shift in the employment picture, and that some will have serious side effects. One quick example – just about any “Buy American” restrictions will hurt our economy in the long run and have minimal benefits in the short run. The Smoot-Hawley act passed in the early years of the recession is our number one example of the problems of drawing up the bridges and protecting our own workers at the expense of other world markets. On the other hand jobs bills that can reduce structural unemployment through retraining, relocation, and other adaptive strategies are money well spent.
3. Federal Deficit and Debt: This is the trickiest balancing act. It also has the most heat and the least amount of light in media discussions. Here’s what the Congressional Budget Office says about the near term situation:

CBO projects, that if current laws and policies remained unchanged, the federal budget would show a deficit of $1.3 trillion for fiscal year 2010. At 9.2 percent of gross domestic product (GDP), that deficit would be slightly smaller than the shortfall of 9.9 percent of GDP ($1.4 trillion) posted in 2009. Last year’s deficit was the largest as a share of GDP since the end of World War II, and the deficit expected for 2010 would be the second largest.

One way to look at this issue is represented by Paul Krugman:

Contrary to what you often hear, the large deficit the federal government is running right now isn’t the result of runaway spending growth. Instead, well more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, required federal bailouts of financial institutions, and been met — appropriately — with temporary measures to stimulate growth and support employment.

Gregory Mankiw is less happy about projected deficits:

The troubling feature of Mr. Obama’s budget is that it fails to return the federal government to manageable budget deficits, even as the wars wind down and the economy recovers from the recession. According to the administration’s own numbers, the budget deficit under the president’s proposed policies will never fall below 3.6 percent of G.D.P. By 2020, the end of the planning horizon, it will be 4.2 percent and rising.

My own take? Closer to Krugman than Mankiw, but I worry that a partial economic recovery or some call for fiscal stimulus will produce not-well-thought-out-spending plans. These won’t help much, in terms of recovery, they are likely to be persistent beyond the current economic problems, and they won’t help re-establish a deficit closer to 4-5% of GDP.

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:

1. 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.
2. 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.