Bernanke grades the Fed

Fed Chair Ben Bernanke’s observations on monetary policy and the housing bubble have received a lot of attention. Like many other commentators (e.g., Arnold Kling, Paul Krugman, and Free Exchange), I agree with Bernanke’s conclusions, but only up to a point.

Bernanke was responding in part to the suggestion by John Taylor and others that much of the blame for the housing bubble might be placed on excessively low interest rates between 2003 and 2005. Bernanke argues that the particular numbers one uses for parameters of a Taylor Rule and measures of the inflation rate and output gap are subject to alternative interpretation, making the proposition that the interest rate was too low over this period much less clear-cut than Taylor’s writings might seem to suggest. Bernanke concludes that the problems in mortgage lending resulted primarily from inadequate regulation rather than from Greenspan having picked the wrong value for the fed funds rate.

I certainly agree with Bernanke that institutional problems were a more important factor than the level of the fed funds rate. However, it would be very hard to argue that the Fed’s targeted interest rate made no contribution. Bernanke frames most of his discussion in terms of the aggregate inflation rate and aggregate level of output, with the purpose of the Fed’s targeted interest rate taken to be achieving a desired outcome for those objectives. But I would suggest that monetary policy does not have the ability to move all industries and all prices uniformly together. By keeping interest rates low, the Fed doesn’t boost all activities, but instead preferentially stimulates particular sectors, housing investment being perhaps the single most important example.

The question we should be asking is then the following. Suppose we believe that in 2004 (a) aggregate output was below potential output (as a result of the slow recovery from the 2001 recession), and (b) house prices and residential investment were unsustainably high (as a result of the agreed-upon lax regulatory structure). Does it follow that the optimal policy should have been to use low interest rates to stimulate housing further in the hopes of making progress with goal (a)?

My answer is no. At least with the benefit of hindsight, I would have thought we could agree that the low interest rate targets of 2003-2005 were a mistake, because more stimulus to housing was the last thing the economy needed. This is not to deny that higher resource utilization rates were a possibility at the time. But I see this as one more illustration, to add to a long string of earlier historical examples, that it is possible to ask too much of monetary policy. Even if the unemployment rate is above where you want it to be and above where you expect it eventually to go, trying to bring it down faster by keeping the monetary gas pedal all the way to the floor can sometimes create bigger problems down the road.

Problems so big that they may make the demons you were trying to fight with that 1% interest rate in 2004 look pretty mild by comparison.

41 thoughts on “Bernanke grades the Fed

  1. Manfred

    I have a question/comment regarding Bernanke’s speech [I was there Sunday morning]. In Slide 9 Bernanke [he takes it from an IMF study] compares housing prices and Taylor rules in different countries, including the US, France, Spain, Germany, etc. But France, Spain, Germany do not have independent monetary policies [or better, they do not have monetary policies, period; only the Euro area as a whole has a monetary policy]. It is like comparing the US with Texas or California or Georgia monetary policies; states in the US do not have it. It is not clear the comparison Bernanke [and the IMF] are making sense to me.
    Nobody called Bernanke on that.
    Can anybody explain to me if and where I am going wrong?

  2. David Beckworth

    There are number of reasons why the low-interest policies of the early-to-mid 2000s were distortionary. I lay some of them out here

    . For now I would note that Tobias Adrian and Hyun Song Shin’s work on the “risk-taking” channel show the low federal funds rate were pivotal in spurring on some of the big, leveredged bets by financial instutions.

  3. Get Rid of the Fed

    “The question we should be asking is then the following. Suppose we believe that in 2004 (a) aggregate output was below potential output (as a result of the slow recovery from the 2001 recession), and (b) house prices and residential investment were unsustainably high (as a result of the agreed-upon lax regulatory structure). Does it follow that the optimal policy should have been to use low interest rates to stimulate housing further in the hopes of making progress with goal (a)?”

    NO! Stop trying to price inflate with debt!!!

  4. HZ

    Are economists soft on Bernanke because he is one of their own?
    How does interest rate policy work? Through asset pricing. Without the housing (and other asset) price inflation and the associated MEW and building boom, Mr. Greenspan would have looked downright impotent. He needed (and got) the housing bubble.
    It is also disingenuous of Mr. Bernanke to suggest that better regulation would have stopped it. Yes banking 101 says prudent lending should be based on ability to repay rather than value of collateral, but in reality with collateral value rapidly appreciating there is practically no way a bureaucrat sitting in a Fed/FDIC office could tell the two apart. How is a bank examiner to tell a bank to stop lending or raise capital or raise lending standards when there is little default (and so all banks look good and it is hard to tell the good ones from the bad ones)? It is far easier to look at the overall picture (instead of micro data at individual banks) and say this is a bubble and it will pop since it can’t continue indefinitely.

  5. Adam P

    Seems to me the problem with blaming the low Fed funds rate is that in the early 2000s the Greenspan Fed was primarily concerned with deflation.
    Moreover, they had a good reason for this. Remember that the Chinese currency peg generates inflationary pressure in China but deflationary pressure in the US.
    Seems perfectly likely that had the Fed tried to fight the housing bubble with higher interest rates we might have just ended up with high unemployment and a long grinding deflation that might not be any better, and could be worse, than our present situation.

  6. E. Barandiaran

    Manfred, read footnote 17 in page 18 of Bernanke’s paper. He could (should?) have done the same exercise for the 50 states.

  7. sjp

    I think Adam P is on target — the real-time data on core inflation looked awfully deflationary circa 2003-04. I don’t think the Fed was responding as much to real-side variables during that episode.

  8. ppcm

    Interesting findings from BIS (P40)
    Stress tests are unable to identify negative macro feed back of systemic nature, and moreover these stress tests are blind in the high growth case scenario above 83 PCT failures.
    Without stretching the results, how could Central Banks be so securely broadcasting their innocence?
    No one has attempted to include:
    Leverages (derivatives and cash,interest rates as enablers,banks balance sheets,money supply) in the stress tests past and present.
    Unlinking of revenues and incomes with assets prices (excluding Case Schiller )

  9. Cedric Regula

    Rough quote from T. Geithner this morning on CNBC, “We don’t like the idea of the Fed being in the mortgage business, which they are when they buy all this MBS, but if the housing market doesn’t improve, we may have no choice but have them continue to buy more MBS.”
    This plus recent speeches by Ben count for a big downgrade in my book. We are moving to a permanent “Capital Command Economy”, and I think they are not trying hard enough when they conclude they have “no choice”.
    So now we have 8000 banks originating mortgages, they have their choice of sending them to F or F, FHA is in there somewhere, then F or F bundles them into MBS and sells them to the Fed?????
    Keynes said you should dig holes, then fill them up, not just dig holes.
    And since when is the Treasury Secretary spokesman for the Fed, and refers to both branches of government as “we”?

  10. Doug

    Bernanke placed a lot of blame on the ‘exotic’ mortgage products. What he did not discuss was why these products were created. None of the organizations originating these loans planned to hold them. The loans were designed and originated to be sold into the securities market. So why was the demand in the securities market so strong for these products? Because the return on alternatives was very low. To make no connection between the low returns caused by monetary policy and the strong demand for products that were thought to provide a better return, leaves a large hole in Bernanke’s case.

  11. pat

    Adam P was correct in the sense that Greenbook in 2003 was forecasting something like less than one percent core PCE for 2004. But it was not news that there are huge error bands around inflation and growth forecasts, and it was not news that there are typically big revisions to current releases. In fact, my non-economist spouse can tell you the joke about the difference between economists and meteorologists: the latter can tell you exactly what the weather was like yesterday. That is why I think arrogance is partly to blame for FOMC’s failing.
    If one cannot forecast well, at least one should have the humility to not act as if they know the future. This was what I (and some of my colleagues in a regional fed) was arguing, against the reduction of ff rate in 2003, as well as BB’s promise of keeping it at 1% for “considerable time”. BB was instrumental in getting that phrase into FOMC statements — and it took them 3 or 4 meetings just to get rid of that phrase before they could actually raise the rate …
    And why BB wanted to get that phrase into FOMC statements? To influence the longer-term interest rates lower, such as mortgage rates, which would then boost housing prices. As he put it in 2007: “…the ability to influence longer-term interest rates and the prices of longer-term assets is an important component of the Fed’s toolkit for managing aggregate demand.”
    It is disingenuous for him to claim Fed couldn’t/shouldn’t prick the housing bubble, he was inflating the bubble and he knew it.

  12. E. Barandiaran

    Adam P, you say
    “Remember that the Chinese currency peg generates inflationary pressure in China but deflationary pressure in the US.”
    You don’t give any reason for both parts of your statement to be true. Apparently you believe JH’s idea of a monetary-induced boom in China, but you should know that there is no evidence to support this idea.
    It’s my view that given the high domestic savings ratio of the Chinese people, if the peg had been generating any pressure on CPI, it’d have been deflationary.

  13. pat

    Doug made an excellent point — again, it is disingenuous for Bernanke not to mention the connection. He used to lecture people on this: one of the transmission mechanisms of monetary policy is that lower ff rates boost prices of many asset classes, including the risky ones.

  14. Adam P

    If an economy finds itself on a full-employment consumption trajectory that is only consistent with a negative real rate (via consumption Euler equations) then the only way to maintain full employment is to inflate something (and promise to continue).
    Is it not possible that a Fed that correctly assesed that it was facing such a situation and responded by mainting full-employment by maintaining the required high inflation rate might later be faulted for that?
    After all, ex-post what we would all look back on was 10 years of high inflation with stable real growth and full employment. Might it not be the case that people would fail to realize that the inflation was the only way maintain full employment?
    Finally, are you certain that the US hasn’t faced this for the last 10-12 years?
    Had the banks been properly regulated the inflation might have been more general instead of concentrated on housing and there would have been no financial crises and probably no recession (perhaps a mild one to get oil prices down from $150, but maybe not).
    Are you sure that monetary policy wasn’t spot on and the whole problem was a failure of basic capital requirements regulation?

  15. Adam P

    PS: it seems to me that the dotom bubble and the crash of 1987 are strong evidence that the problem is not the bursting of a bubble per se but the excess leverage.
    Regulation would have taken care of the crazy leverage ratios, make them keep stuff on balance sheet and keep enough good quality capital.

  16. tyaresun

    What are the regulatory reponsibilities of the Fed? Why does the Fed not admit any mistakesin this area? Why do economists such as yourself defend the Fed so much?
    Here is a short Wiki excerpt on the Fed’s regulatory reponsibilities:
    [edit] Government regulation and supervision
    Ben Bernanke (lower-right), Chairman of the Federal Reserve Board of Governors, at a House Financial Services Committee hearing on February 10, 2009. Members of the Board frequently testify before congressional committees such as this one. The Senate equivalent of the House Financial Services Committee is the Senate Committee on Banking, Housing, and Urban Affairs.The Board of Governors in the Federal Reserve System has a number of supervisory and regulatory responsibilities in the U.S. banking system, but not complete responsibility. A general description of the types of regulation and supervision involved in the U.S. banking system is given by the Federal Reserve:[44]
    The Board also plays a major role in the supervision and regulation of the U.S. banking system. It has supervisory responsibilities for state-chartered banks that are members of the Federal Reserve System, bank holding companies (companies that control banks), the foreign activities of member banks, the U.S. activities of foreign banks, and Edge Act and agreement corporations (limited-purpose institutions that engage in a foreign banking business). The Board and, under delegated authority, the Federal Reserve Banks, supervise approximately 900 state member banks and 5,000 bank holding companies. Other federal agencies also serve as the primary federal supervisors of commercial banks; the Office of the Comptroller of the Currency supervises national banks, and the Federal Deposit Insurance Corporation supervises state banks that are not members of the Federal Reserve System.
    Some regulations issued by the Board apply to the entire banking industry, whereas others apply only to member banks, that is, state banks that have chosen to join the Federal Reserve System and national banks, which by law must be members of the System. The Board also issues regulations to carry out major federal laws governing consumer credit protection, such as the Truth in Lending, Equal Credit Opportunity, and Home Mortgage Disclosure Acts. Many of these consumer protection regulations apply to various lenders outside the banking industry as well as to banks.
    Members of the Board of Governors are in continual contact with other policy makers in government. They frequently testify before congressional committees on the economy, monetary policy, banking supervision and regulation, consumer credit protection, financial markets, and other matters.
    The Board has regular contact with members of the Presidents Council of Economic Advisers and other key economic officials. The Chairman also meets from time to time with the President of the United States and has regular meetings with the Secretary of the Treasury. The Chairman has formal responsibilities in the international arena as well.
    [edit] Preventing asset bubbles
    The board of directors of each Federal Reserve Bank District also have regulatory and supervisory responsibilities. For example, a member bank (private bank) is not permitted to give out too many loans to people who cannot pay them back. This is because too many defaults on loans will lead to a bank run. If the board of directors has judged that a member bank is performing or behaving poorly, it will report this to the Board of Governors. This policy is described in United States Code:[45]
    Each Federal reserve bank shall keep itself informed of the general character and amount of the loans and investments of its member banks with a view to ascertaining whether undue use is being made of bank credit for the speculative carrying of or trading in securities, real estate, or commodities, or for any other purpose inconsistent with the maintenance of sound credit conditions; and, in determining whether to grant or refuse advances, rediscounts, or other credit accommodations, the Federal reserve bank shall give consideration to such information. The chairman of the Federal reserve bank shall report to the Board of Governors of the Federal Reserve System any such undue use of bank credit by any member bank, together with his recommendation. Whenever, in the judgment of the Board of Governors of the Federal Reserve System, any member bank is making such undue use of bank credit, the Board may, in its discretion, after reasonable notice and an opportunity for a hearing, suspend such bank from the use of the credit facilities of the Federal Reserve System and may terminate such suspension or may renew it from time to time.

  17. Cedric Regula

    Manfred January 5, 2010 06:38 PM,
    “In Slide 9 Bernanke [he takes it from an IMF study] compares housing prices and Taylor rules in different countries, including the US, France, Spain, Germany, etc. ”
    This one has me laughing so hard, I’m in tears. Add to the fact that not only do these countries not have their own CB, but different regulatory rules, underwriting standards and tax law vs each other and the US, lack of a international mortgage market that we enjoy thru GSEs in the US and the associated capital inflows, different personal incomes therefore different affordability, plus the fact that the Taylor Rule is an empirical concoction which attempts tying together the twin tasks of stable prices and minimizing output gap into one nifty, easy to use formula, whose definition of the variables, not to mention coefficients, varies greatly upon whom is cooking up the “Rule”, is certainly a big acid trip thru the looking glass into Alice in Wonderland.
    I truly hope that Ben doesn’t really believe it.

  18. John Hicks

    I think we also should consider certain political economy dimensions of monetary policy during this time, especially for Greenspan. I seem to recall that something rather important occurred in November 2004. The Fed reduced its targeted funds rate by 25 bps in June 2003 to one percent. The Fed held the rate at that level for a solid year, despite fairly robust output (though not employment) growth in the second half of 2003 and first half of 2004. Clearly, this behavior is in keeping with the usual Fed policy of monetary goosing for Republican administrations. The rest, as they say, is history. I have no doubt that the Fed will start aggressively tightening monetary policy about 18 months before November 2012.

  19. David Pearson

    Bernanke misses a key connection: low policy rates contributed directly to the loosening of lending standards. This occurred through two channels.
    First and foremost, the market perceived the Fed was putting a floor under asset prices with its asymmetric monetary policy. This was the well-known “Greenspan Put”. That, plus flawed econometric modeling, caused some very intelligent people to conclude that nominal house prices would never fall, and therefore that leveraged, collateral-based lending made sense. There is a common misunderstanding that securitization caused the bubble by divorcing underwriting and investing. Not so. The peculiar characteristic of securitization in 2003-2007 was HOW MUCH of the risk was put on the balance sheets of the securitizers, many of whom eventually failed as a result. No, the cause of the crisis was that asymmetric policy led these originators to collect collateral risk on their balance sheets.
    Second the Fed’s policy lowered standards in a more operational way. 2003 was a boom and peak year for mortgage originations — primarily ARM refinancings. Any mortgage originator needed something to replace those peak-level originations if they wanted to show earnings growth. This led directly to the development of higher-margin products such as option arms.

  20. Cedric Regula

    Been working on another formula, except my very own financial formula, which I’m going to copyright the “Regula Rule”.
    Fannie + Freddie + FHAllelujah! = Fuld Reserve
    Sound good?

  21. Cedric Regula

    tyaresun at January 6, 2010 09:41 AM
    on Wiki highlight of Fed regulatory responsibility.
    Glad you posted this. One thing everyone, and especially Al_Ben, have been attempting to sweep under the rug is the regulatory authority the Fed does have.
    It is certainly the case that we had the executive branch, legislative branch and GSEs pulling every trick in their respective domains to grow the housing bubble. The only branch of government that wasn’t involved was the legal branch, as far as I know.
    So I have to put myself in the shoes of a G-12 pay scale FDIC employee and wonder what Ben expects me to do about this. I guess I could say stop, but I wouldn’t have much of a case because there was no current evidence of financial problems. After all, banks were booming, they cleared off their balance sheets with securitization (maybe that’s the job of my buddies in the SEC), but then some of the dummies had to invest all their money by buying back the AAA securitized products or maybe CDOs, CMOs and insure them with CDS.
    Then if I persisted in pushing my weak case, they could simply threaten to call one of their billionaire ex-employees in some high ranking position either directly above me or close enough for government work.
    I would probably have a big mortgage on an overpriced house and decide keeping my job is the better part of valor.
    And if I did really understand all that stuff well enough back then, I would quit, short it, and be a billionaire too!

  22. K

    JDH, Great observation that low rates differentially affect housing, and that’s not what was needed at the time.
    But giving a further boost to housing seemed to be exactly the Fed’s intention at the time—Steve Roach was continually saying that Greenspan was trying to inflate housing to offset the dot com weakness and Roach said it was dangerous business. Roach said basically they were trying to cure the effects of one bubble by creating another. (Greenspan’s advice to take shorter and variable rate mortgages is another fingerprint.) So, while I liked Leonard’s article in the NYT today, there is some reason to believe the Fed wasn’t simply oblivious to the bubble. Instead, encouraging outsized growth in housing activity and prices was exactly the Fed’s intent, and they underestimated the potential problems.
    As an institution, the Fed is as discredited as is the SEC, and in need of at least as much investigation and reform.

  23. Mark A. Sadowski

    JDH wrote:
    “Does it follow that the optimal policy should have been to use low interest rates to stimulate housing further in the hopes of making progress with goal (a) [full employment]?”
    A false dichotomy if I ever did see one. The appropriate choice would have been for the Fed to exercise existing, and to seek much tougher regulation, in housing related markets.
    Monetary policy is far, far too important to be at all compromised by anarchic and irrationally speculative markets.
    Which is more important? Macroeconomic stability or the freedom to engage in mass idiocy?

  24. Cedric Regula

    Mark A. Sadowski,
    In a nutshell, Fed monetary policy failed to inflate Chinese prices in China enough to create a booming tennis shoe and toaster oven manufacturing industry in the US of adequate size to offset the economic contraction we got when the tech boom so abruptly ended(and prolonged by the 911/Iraq shock, IMO)and thru a combination of luck(we still build and sell houses in the US, tho my buddies and I in CA were watching to see if those would come floating into the Port of Long Beach) and circumstances(securitization and GSEs were well developed markets for funding and speculation)we sort of just fell into this housing boom thing. Then the miracle of MEW arrived for every homeowner, giving households another wage earner in the household…their house! All without needing to create a job!
    Soon newer model Bimmers and Porches swarmed thru our freeways, a new set of appliances was in every kitchen, and gas, food and health insurance prices were things that only poor people complained about.
    It was a happy time for most, certainly not idiotic, tho times change and CA now seeks to bequeath the half of CA that disappeared to the rest of the country and the Fed seems destined to be the “bad bank” that receives it.
    “Move one house to the left!” say Californians, and all our problems will be solved!
    JDH in San diego may understand what I’m rambling about.

  25. Mark A. Sadowski

    Cedric Regula,
    Where can I get the stuff you’re tabbing?
    P.S. I’m only half kidding. I haven’t experienced stuff that good in a very long time. 😉

  26. Mark A. Sadowski

    In memory of dear old Momma:
    “Well, I was borned a coal miner’s daughter,
    In a cabin, on a hill in Butcher Holler.
    We were poor but we had love,
    That’s the one thing that Daddy made sure of,
    He shoveled coal to make a poor man’s dollar.
    My Daddy worked all night in the Van Lear coal mines.
    All day long in the field a hoin’ corn.
    Mommy rocked the babies at night,
    And read the Bible by the coal oil light,
    And ever’ thing would start all over come break of morn.
    Daddy loved and raised eight kids on a miner’s pay.
    Mommy scrubbed our clothes on a washboard ever’ day.
    Why I’ve seen her fingers bleed,
    To complain, there was no need,
    She’d smile in Mommy’s understanding way.
    In the summertime we didn’t have shoes to wear.
    But in the wintertime we all got a brand new pair.
    From a mail order catalog
    Money made from selling a hog,
    Daddy always managed to get the money somewhere.
    Yeah, I’m proud to be a Coal Miner’s Daughter,
    I remember well, the well where I drew water.
    The work we done was hard,
    At night we’d sleep cause we were tired
    I never thought of ever leaving Butcher Holler.
    Well a lot of things have changed since a way back then
    And it feels so good to be back home again.
    Not much left but the floor, nothing lives here anymore,
    Except the memory of a Coal Miner’s Daughter”
    P.S. PhD. in economics or naught.

  27. robert

    can anyone explain how lax regulation that creates systemic risk is somehow absent massive criminal or civil prosecution of the core vehicles (ie the too big too fail crowd)?

  28. Cedric Regula

    It’s not against the law.
    They did just complete a trial with two Bear Sterns hedge fund managers. They tried to charge them with selling CDOs to hedge fund clients(you have to be a millionaire and a half to be a hedge fund client), when there was e-mail evidence that the hedge fund managers had some privately held misgivings about the true worth of CDOs.
    The jury said not guilty.
    They did get Bernie.

  29. Cedric Regula

    I lifted this post from Calculated Risk today.
    These are banking advisories our gov agencies are sending out to the banks. To paraphrase, they are saying that banks should exercise extreme caution(may be either a red or yellow alert, methinks) in borrowing short and lending long, because interest rates are low for a considerable and extended time, may go up, and all their securitized capital may become impaired.
    Glad they told everyone. Forewarned is forearmed!
    From the FDIC: FDIC Issues Interest Rate Risk Advisory
    The Federal Deposit Insurance Corporation (FDIC), in coordination with the other member agencies of the Federal Financial Institutions Examination Council (FFIEC), released an advisory today reminding institutions of supervisory expectations for sound practices to manage interest rate risk (IRR).

    The member agencies of the FFIEC include the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the FFIEC State Liaison Committee. The FDIC currently chairs the FFIEC.
    Here is the advisory: FFIEC Advisory on Interest Rate Risk Management
    The financial regulators1 are issuing this advisory to remind institutions of supervisory expectations regarding sound practices for managing interest rate risk (IRR). In the current environment of historically low short-term interest rates, it is important for institutions to have robust processes for measuring and, where necessary, mitigating their exposure to potential increases in interest rates.
    Current financial market and economic conditions present significant risk management challenges to institutions of all sizes. For a number of institutions, increased loan losses and sharp declines in the values of some securities portfolios are placing downward pressure on capital and earnings. In this challenging environment, funding longer-term assets with shorter-term liabilities can generate earnings, but also poses risks to an institutions capital and earnings.
    The regulators recognize that some degree of IRR is inherent in the business of banking. At the same time, however, institutions are expected to have sound risk management practices in place to measure, monitor, and control IRR exposures.
    emphasis added
    The agencies recommended the following stress testing …
    When conducting scenario analyses, institutions should assess a range of alternative future interest rate scenarios in evaluating IRR exposure. … In many cases, static interest rate shocks consisting of parallel shifts in the yield curve of plus and minus 200 basis points may not be sufficient to adequately assess an institutions IRR exposure. As a result, institutions should regularly assess IRR exposures beyond typical industry conventions, including changes in rates of greater magnitude (e.g., up and down 300 and 400 basis points) across different tenors to reflect changing slopes and twists of the yield curve.

  30. wally

    Don’t get sucked into Bernanke’s unstated premise that the world began in 2002, more or less, for the Fed – that circumstances were externally imposed and the Fed was restricted in its actions. The earlier tech bubble created those initial 2002 conditions and the Fed bears responsibility for that, too. The Fed helped put the economy on a roller coaster and now claims each new hill is an event for which they cannot be accountable. The problem is, it has to stop somewhere; at some point a responsible Fed would clean up its act and approach its responsibilities in a long-term manner.

  31. MarkS

    I’m with Adam P.
    I never stop being mystified as to why central bank economic management continues to ignore the overall leverage (debt level) of the economy. There is no doubt, that increasing debt/income ratios will inevitably impair future economic growth and burden future generations with current perfidy. Western economies have experienced recurrent cycles of credit expansion and banking collapse for at least the last 400 years. Can anyone explain why government (FED) policy can not limit overall credit to no greater than 50% of real* GDP? Can anyone explain why overall leverage rarely is a subject of discussion among the economic literati, the FROMC, or the Treasury?
    *real GDP being defined as tradable output= export services, export construction, manufacturing, agriculture, mining… (ie: domestic services and domestic construction are not included).

  32. Major

    Low rates enabled: speculators to use unregulated, untaxed and off-book SIVs to:
    a) Cheaply borrow ALL the money needed to buy up HUGE pools of shabby mortgages
    b) Issue MANY securities (MBS)based upon the “sure-thing” revenue-streams expected from those HUGE piles of mortgages.
    c) Sell the securities — Price to include not only NPV of the (expected) revenue stream but also scads of underwriting and other fees.
    d) Walk away WITH the sales proceeds — untaxed, off-shore, in cash, etc. — and leave the Greater Fools with all the risk while keeping all the sales proceeds.
    THAT’s how low-interest rates enabled AND encouraged the use of all the borrowed money GS and friends could lay their hands on!

  33. Cedric Regula

    I’ve been wondering that too. Then I remembered my monetary theory. They influence the cost of credit using interest rates which is supposed impact demand for credit which is their lever over aggregate demand and business investment.
    But then they don’t check if everyone is about to go bankrupt or not. They missed it with corporate debt in the late 90s. This decade it was consumer credit, residential and commercial real estate mortgages, and government debt is exempt from the the concept because of the printing press solves all problems theory.
    Then they don’t seem to evaluate the details of how business investment is going either. Like M&A, stock buybacks and foreign investment don’t do much for US employment. And low rates won’t make biz invest if they can’t make a positive case for ROI.
    If they keep doing this, we will need to make economics illegal. This practice is a danger to society.

  34. Mark A. Sadowski

    I’m still here. What’s more I’m probably the person who’s going to make you feel sure sorry.

  35. Luis H Arroyo

    Booming leverage is the kee -I think. Between the FF and the bank Loan rate there is a world of reason that explain this booming leverage. But remember that a the same time there were a lot of reason to a low FF: for example, the very exceptional low rate of treasury debt and the high dollar, that in its turn was the main cause of huge external deficit; that, as say Bernanke, was at odd with a high FF…
    Was the low FF responsable of the external deficit and the huge capital inflow financing it? What would have been the consequences of a 3% FF, as Taylor recommend ex post? Possibly, a higher capital inflow and a higher Dollar.
    I think the slide 10 of Bernanke is very interesting. See, for example the RU case: a bigger buble than in US, but with a very less accomodative MP (the offcial interest rate was never lower than 4%, with an PCI below 2%).
    We have some elements in favor of higher FF, but also some others against it.

  36. Darko Oracic

    The focus on housing is too narrow. Total private investment should be included in the analysis. Only then the role of the Fed in the 2001-2008 turbulences becomes clear. Real investment growth was almost perfectly correlated to the federal funds rate lagged one year (t-1). The correlation is -0.95. Just a coincidence? I don’t think so.

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