Bernanke erroneously claims Federal Reserve didn’t cause the housing bubble
The Federal Reserve did not directly cause the housing bubble. The lowering of interest rates in 2002 did help boost prices and may have served as a precipitating factor contributing to the housing bubble, but monetary policy of the Federal Reserve itself was not the cause.
That doesn’t mean the Federal Reserve doesn’t have significant responsibility for the housing bubble.
The primary cause of the housing bubble was the influx of private capital into the mortgage market through mortgage-backed securities. So why did this happen? First, when the Federal Reserve lowered interest rates to 1% under Alan Greenspan, investors sought out higher yields. Mortgages became the vehicle of choice because the relatively low yields were still better than competing investments, and there was the perception of little risk in mortgages backed by real estate. After all, real estate only goes up.
This leads to the second policy of the Federal Reserve that contributed to the housing bubble. Alan Greenspan decided not to regulate the complex financial insurance arrangements known as credit default swaps. Through the sale of credit default swaps, lenders were able to package MBS pools and insure them against loss. With no risk of loss, investors dumped trillions of dollars into residential mortgages and inflated a massive housing bubble.
An extention of Alan Greenspan’s failure to regulate credit default swaps was his failure to regulate exotic mortgage products like Option ARMs. The negative amortization loan allowed borrowers to obtain mortgage balances twice as large as they could support. Options ARMs were the delivery mechanism that injected the air in the housing bubble.
These three errors inflated the housing bubble. To recap: first, the federal reserve lowered interest rates prompting investors to chase yields in mortgages. Second, credit default swaps foolishly unregulated by the federal reserve emboldened investors to pump nearly unlimited amounts of capital into what were perceived as riskless investments. And third, the unregulated Option ARM enabled individual borrowers to pump up the mortgage balances on properties to ridiculous and unsustainable levels. If the Federal Reserve had not lowered interest rates to 1%, decided to properly regulate credit default swaps, or prudently banned negative amortization loans — all of which was within their powers as master regulator of American banks — the housing bubble would not have inflated here in the United States.
Bernanke himself noted the housing bubble was a worldwide phenomenon; therefore, the Federal Reserve was not the cause. While it’s true that the Federal Reserve’s policies did not inflate the housing bubbles in other countries, it’s worth noting that many other countries made the same mistakes we did. The housing bubbles did not inflate on their own, and many countries with more regulated banking did not participate in the world housing bubble.
“A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him. It is necessarily part of the business of a banker to maintain appearances, and to confess a conventional respectability, which is more than human. Life-long practices of this kind make them the most romantic and the least realistic of men.”
— John Maynard Keynes, “The Consequences to the Banks of the Collapse in Money Values”, 1931
By Annalyn Censky @CNNMoneyMarch 22, 2012: 3:04 PM ET
Federal Reserve Chairman Ben Bernanke gave a lecture to a class at George Washington University, telling students that monetary policy did not cause the housing bubble.
NEW YORK (CNNMoney) — The Federal Reserve isn’t to blame for the housing bubble, Ben Bernanke told a lecture hall full of college students Thursday.
But the students wouldn’t let the Fed Chairman off the hook.
“The slides on the housing bubble show how clearly one thing led to another,” said Daniel Lippman, a senior at George Washington University. “When you were observing the economy in the 2000s, what did you think would happen to rising house prices and the housing bubble?”
Bernanke responded: “Well, as I tried to argue, the decline in house prices by itself was not obviously a major threat.”
“It was that whole chain of events that was critical,” he added.
Earlier in the lecture, Bernanke said the Fed had little to do with home prices that rose rapidly in the early 2000s, and then came crashing down.
Bernanke pointed to housing booms and busts around the world as evidence that the rise in real estate prices was not limited to the United States and the Fed’s area of influence.
What Bernanke points to as evidence of powers beyond his control is actually evidence of the collective incompetence of central bankers around the world.
He also cited research by economist Robert Shiller showing the housing bubble began in 1998 — three years before the Fed started slashing interest rates — making it cheaper to get a mortgage.
Robert Shiller made no such claim. The housing bubble began to inflate in the early 2000s on the coasts, but it wasn’t until the widespread use of the Option ARM in 2003 that prices really got stupid nationwide.
“You’ll probably hear different points of view, but the evidence that I’ve seen and that we’ve done within the Fed suggests that monetary policy did not play an important role in raising house prices during the upswing,” Bernanke said.
The lecture was part of a four-part series at George Washington University that continues next week. The Federal Reserve posts Bernake’s slides and full videos online.
Bernanke is fortunate he was addressing an audience who was not in a position to call him on his laughable arguments and false claims. If I had been there, he would not have been so fortunate.