Monday, March 23, 2009

What were they thinking?

Was running google searches and stumbled across this interesting New York Times article from 2005. It gives a good idea of the sort of thinking that was going on at the Federal Reserve and in Washington at the height of the housing bubble.

Laurence H. Meyer, a former Fed governor and now a principal at Macroeconomic Advisers, said the evidence of risky lending practices was abundant. Even though mortgage rates remain at their lowest point in decades, more than half of all new mortgages are either interest-only loans or adjustable-rate loans that start out cheap but can become very costly if rates rise.

"These kinds of mortgages are feeding higher prices but they are also the kinds of loans that are most vulnerable to distress," Mr. Meyer said.

The issue of a possible housing "bubble," where prices become inflated by unrealistic expectations of even higher prices in the near future, poses difficult issues for the Fed.

Mr. Greenspan and other officials have long argued that it is not their job to influence the price of assets whether stock prices or real estate. Rather, they contend, the central bank's job is to keep inflation low and to promote the maximum sustainable growth without fueling inflation.

It's a myth that no one saw this coming. Plenty of people were warning that the loans that were fueling the bubble were risky ones, with very high probabilities for default. But the Federal Reserve was wedded to the idea that intervention to stymie bubbles was bad policy.

Here's Ben Bernake in 2002:

If we could accurately and painlessly rid asset markets of bubbles, of course we would want to do so. But as a practical matter, this is easier said than done, particularly if we intend to use monetary policy as the instrument, for two main reasons. First, the Fed cannot reliably identify bubbles in asset prices. Second, even if it could identify bubbles, monetary policy is far too blunt a tool for effective use against them.
Although neither I nor anyone else knows for sure, my suspicion is that bubbles can normally be arrested only by an increase in interest rates sharp enough to materially slow the whole economy. In short, we cannot practice "safe popping," at least not with the blunt tool of monetary policy. The situation is further complicated if, as is usually the case, the suspected bubble affects only a specific class of assets, such as high-tech stocks. Certainly there is no way to direct the effects of monetary policy at a single class of assets while leaving other financial markets and the broader economy untouched. One might as well try to perform brain surgery with a sledgehammer.
Understandably, as a society, we would like to find ways to mitigate the potential instabilities associated with asset-price booms and busts. Monetary policy is not a useful tool for achieving this objective, however. Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.

A far better approach, I believe, is to use micro-level policies to reduce the incidence of bubbles and to protect the financial system against their effects. I have already mentioned a variety of possible measures, including supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed. Although eliminating volatility from the economy and the financial markets will never be possible, we should be able to moderate it without sacrificing the enormous strengths of our free-market system.

Bernake may or may not be right to insist that a change in the Federal funds rate is too blunt of an instrument to employ in tamping down an economic bubble. He is certainly right to suggest that the government should have made use of the other tools at its disposal, also. There is no question that lax regulation contributed to fiasco, for instance, and attempts by libertairans to blame the economic meltdown solely on the Federal reserve are little more than articles of faith by those who refuse to accept that bad results are possible from an unregulated market.

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