John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates

TO BE NOTED: Antonio Fatas and Ilian Mihov on the Global Economy:


"Three different views on the role of monetary policy leading to the current crisis

John Taylor thinks that the Federal Reserve is to blame for the crisis because of the low interest rates in the year 2003-2005 period.

"Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience. Keeping interest rates on the track that worked well in the past two decades, rather than keeping rates so low, would have prevented the boom and the bust."

You can see the full article at the Wall Street Journal (Feb 9, 2009).

Alan Greenspan, as you would expect, disagrees with John Taylor and claims that the central bank was doing the right thing but the problem was the disconnect between short-term interest rates and mortgage rates (which were being kept too low partly because of the increase in saving rates coming from Asia).

"Given the decoupling of monetary policy from long-term mortgage rates, accelerating the path of monetary tightening that the Fed pursued in 2004-2005 could not have "prevented" the housing bubble. All things considered, I personally prefer Milton Friedman's performance appraisal of the Federal Reserve. In evaluating the period of 1987 to 2005, he wrote on this page in early 2006: "There is no other period of comparable length in which the Federal Reserve System has performed so well. It is more than a difference of degree; it approaches a difference of kind.""

You can see the full article at the Wall Street Journal (March 11, 2009).

Lucas Papademus, Vice President of the ECB looks forward in a recent speech (May 15, 2009) and asks what monetary policy should do in a similar future situation. He advocates for a symmetric reaction of monetary policy: not only it makes sense to lower rates when the crisis starts but central banks should also act when financial imbalances are accumulating.

"In order to reduce such potentially dangerous side-effects of non-standard measures of liquidity provision and of the very low policy rates during a crisis, monetary policy would have to be sufficiently tightened during the financial boom phase. Such a policy would dampen financial market excesses through two channels. It would tend to reduce asset prices by increasing the rate at which an asset’s future income stream is discounted. Most importantly, the anticipation of such a policy response would reduce the likelihood of a speculative bubble emerging in the first place, by affecting investment behaviour and reducing the level of risk incurred by financial intermediaries in their lending."

Papademus falls short of making a statement on whether interest rates were too low during the years that preceded the crisis (as Taylor argues). But his argument supports the view that standard monetary policy (i.e. via interest rates) also has a role to play in dealing with speculative bubbles in financial markets, it is not just a matter of proper regulation and supervision.

Antonio Fatás"

unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices

From The Atlantic Business:

Richard A. Posner

A Failure of Capitalism

May 19 2009, 9:59PM

A Failure of Capitalism (IV): More on Bubbles

The housing bubble is so central to our current economic troubles, and such a mysterious phenomenon from an economic standpoint, that I want to elaborate on my brief remarks in the previous entry.

A few figures: At the beginning of 2000, the federal funds or overnight rate--the short-term interest rate that the Federal Reserve focuses on influencing through its purchase and sale of Treasury bonds--was 5.45 percent. Though short term, this rate influences long-term rates, because it is the rate at which banks borrow from each other, and the more (less) they borrow ,the more (less) they are able to lend to their customers; and the more (less) they lend, the lower (higher) their interest rates are. Also at the beginning of January 2000, the average interest rate for the standard 30-year fixed-monthly-payment mortgage was 8.21 percent.

By December 2003, when the overnight rate had fallen below 1 percent, the mortgage rate had fallen to 5.88 percent and housing prices had risen (since the beginning of 2000) by 42 percent. The overnight rate than gradually rose, to 5.26 percent in July 2007, by which time the mortgage interest rate had risen to 6.7 percent, yet housing prices had continued to increase and were more than 80 percent above their 2000 level. After that both interest rates, and housing prices, began to decline.

If low interest rates drive up housing prices, high interest rates should (and eventually do), drive them down. Yet we have just seen that housing prices continued rising after interest rates started to rise. Moreover, a leading housing economist, Edward Glaeser, has pointed out to me that, on the basis of studies of the responsiveness of housing prices to interest rates in other periods, it is unlikely that the fall in mortgage interest rates during the early 2000s accounted for more than 20 percent of the increase in housing prices.

What I think we are seeing in the numbers is the classic bubble phenomenon, a phenomenon that has been observed in a variety of markets in a variety of countries for centuries. The low interest rates of the early 2000s pushed up housing prices both directly and indirectly. Directly by reducing the cost of housing debt--and housing as I mentioned in my last entry is bought mainly with debt. Indirectly by pushing up the value of common stocks. The low interest rates, as I said, caused asset-price inflation. Common stock is an asset, and was affected by the inflation. As the market value of people's savings, increasingly concentrated in common stock (whether in brokerage accounts, retirement accounts, college savings plans, or health savings plans), rose, people felt (and were, for the time being anyway) wealthier, and this increased their demand for houses--for owning rather than renting, or for owning a bigger or fancier house than their present house. And banks, including mortgage banks, being able to borrow capital at low rates, for lending, were eager to encourage borrowing by relaxing their credit standards. So people who could not have qualified for a mortgage at any interest rate earlier were now able to borrow at affordable rates.

Once house prices started rising, moreover--and here is the bubble phenomenon at its purest--the increase acquired momentum. An increase in the price of an asset, after that increase has continued for a significant time, creates a belief that the asset is a good value. One sees other people bidding up the price of houses and assumes they know something that perhaps one does not. And when officials and economists, and not just brokers and bankers, say that housing prices are rising because of "fundamental" changes in demand and supply that are likely to continue, the belief that a house is a good value, even though it costs a good deal more than it would have cost just a year or two ago, is fortified. There is nothing irrational about such a belief, or about action on it, though there is always a risk that the apparent increase in value will turn out to be a bubble phenomenon.

That seems to be what happened, and the basic fault lies with the Federal Reserve in having pushed interest rates too far down, and kept them too far down for too long, during the early 2000s, and with the dismantling of regulatory controls that had formerly reduced the incentive and ability of banks to lend into a bubble."

Me:

Don the libertarian Democrat May 20, 2009 12:38 PM

I know that I must be wrong, but here's what I saw in the Central Valley of CA: As housing prices climbed, the wealth of the people buying the houses declined. In other words, the people in the worst economic shape were buying at the top of the market. Call me crazy, but that didn't, and still doesn't, sound right.

Now, when interest rates are first lowered, and people who have the means decide that this is a good time to buy, I can understand that. That's when people of limited means should be buying, if they have the savings and income. It should not take too great a rise for these marginal buyers to decide to wait and keep saving. That's my story.

I can, of course, concoct an asinine story for people to keep buying in such a scenario, but it doesn't have to do solely with interest rates: namely, you convince marginal buyers that, if they don't buy a house now, then they will never be able to buy a house. It's a story, a theory, a prediction, but, as Jeeves would say, it's unsound.

The interest rate story works for a bit at the beginning, but then it cannot account for what happens next. As rates started to rise, I can imagine hearing "you had better buy quick". I just don't see the evidence that anything less than a massive and quick increase would have saved us this misery, as long as people were buying into a story that had to have a bad ending for them.

Previewing your Comment

Don the libertarian Democrat May 20, 2009 7:20 PM

I want to add one more point on bubbles before you do another ten posts. For lower income people and many middle income people as well, the narrative was that you'd better buy now or you'll be out of luck. But there was another narrative that contributed to the bubble, and that was that you'll be a pauper when you retire.

There has been an endless warning that social security is iffy for people of a certain age, and that pensions are dying out. Events like Enron employees having their savings blown up contributed to this. Consequently, buying a house was considered by many to be the main option for providing for old age. Why was this so? Because you have to spend money for housing. Renting came to be seen as money down the drain, and the rest of people's wages really didn't allow for grand savings.

So people decided that, instead of paying rent, they needed to buy a house. It's hard to describe the sense of panic that many people have over retirement. I bought my house in 1991 in the Bay Area for just that reason. I did not particularly like the idea of owning a house. I sold it early last year. For me, this plan actually worked.

One reason that I'm for a guaranteed income, as proposed by Charles Murray, is precisely because I believe that it would alleviate much of this terror of a pauper's old age, by habituating people to a stable social safety net. In other words, I'm claiming that the bubble wouldn't have occurred without this life or death feeling that people had about buying a house to provide for their retirement. Being a novelist and philosopher, I've now done my part.