How the Fed helped cause the housing bubble and financial crisis


John Taylor in the WSJ:

The Fed’s mistake of slowing money growth at the onset of the Great Depression is well-known. And from the mid-1960s through the ’70s, the Fed intervened with discretionary go-stop changes in money growth that led to frequent recessions, high unemployment, low economic growth, and high inflation.

In contrast, through much of the 1980s and ’90s and into the past decade the Fed ran a more predictable, rules-based policy with a clear price-stability goal. This eventually led to lower unemployment, lower interest rates, longer expansions, and stronger economic growth.

Unfortunately the Fed has returned to its discretionary, unpredictable ways, and the results are not good. Starting in 2003-05, it held interest rates too low for too long and thereby encouraged excessive risk-taking and the housing boom. It then overshot the needed increase in interest rates, which worsened the bust. Now, with inflation and the economy picking up, the Fed is again veering into “too low for too long” territory. Policy indicators suggest the need for higher interest rates, while the Fed signals a zero rate through 2014.

Wait, the Fed had a role in causing the financial crisis? I thought it was all Wall Street’s fault. As it so happens, there is a study out today that draws a similar conclusion:

Our analysis has shown that interest rates that are set too low for too long have a significant impact on the creation of housing bubbles. The strong link between deviations of short-term rates from Taylor-implied rates and housing bubbles suggest that in order to lean against house price fluctuations, it is not necessary to consider house prices directly in monetary policy decisions if policymakers set interest rates at levels close to those implied by the Taylor rule.

Our results highlight the additional complexity of maintaining an appropriate policy interest rate for a group of countries like the Eurozone that experience substantial heterogeneity in both the real estate markets as well as in the real economy. As we have seen, Taylor-implied rates as well as the development of house prices differ substantially between some Eurozone countries. Since it is not possible to react to this with a single monetary policy, country-specific measures should be taken to compensate for too low interest rates and in order to avoid a build-up of housing bubbles. This compensation could be achieved, for example, by introducing macroprudential instruments like countercyclical capital requirements for banks, limits for loan-to-income and loan-to-value ratios, or a countercyclical tax treatment of real estate holdings.

Then earlier this month, there was this research, which also put the blame for the financial crisis on easy credit rather than income inequality:

The negative and significant relationship of short-term interest rates and credit growth may also be consistent with the story of for example Taylor (2009) or Meltzer (2010) who attribute the U.S. housing boom to expansionary policy by the Federal Reserve in the early 2000s in an attempt to prevent perceived deflation. Moreover, housing booms and busts in other countries did not reflect redistributive housing policy. In the period before the Great Moderation they occurred during episodes of expansionary monetary policy … it now seems fairly clear from our examination of the data that neither have much to do with rising income inequality.

5 thoughts on “How the Fed helped cause the housing bubble and financial crisis

  1. I have a different view. While easy credit and low rates (along with ‘too big to fail’) provided tinder, by themselves, the ending of easy credit and the pop of the real estate bubble should have caused a fraction of the damage that it did. I feel the real culprit was an inability to quickly and accurately identify and quantify the exposure financial firms had to declines in the value of, in this case, residential mortgage securities. As a result, all firms were tainted… and at risk of being shunned by creditors and trading partners.

    I analogize this to a situation where someone discovers a mouse in a package of cereal. There is a system by which the tainted box can be traced back to a specific shipment from a specific plant to a specific provider. There’s no need to treat all cereal from all manufacturers as tainted. Only that particular cereal from a single manufacturer is shunned.

    That wasn’t the case with Wall Street. Because we didn’t know who had what and how much, we did what was rational: we avoided everybody and anybody who had anything to do with MBSs.

    But had there been a similar system in place, we could have been able to identify who was at risk and to what extent. We wouldn’t have needed to treat every firm as a leper. There wouldn’t have been a panic.

    • “the real estate bubble should have caused a fraction of the damage that it did”

      I agree.
      Although I can’t find a dollar amount that was supposed to have caused the crash, the number they bandied about seemed astronomically high considering the number of actual “toxic” mortgages that there were.

      Something that I think has not been really looked at is the fact that oil prices crashed at the same time. I remember reading stories well before the crash about how pensions and others were investing (SPECULATING) heavily in oil and how much of the crash loses were really related to that, and not the housing.

  2. The root of this problem lies in the Community Redevelpment Act signed by Jimmy Carter and revised by Bill Clinton. That was a classic Progressive/Socialist tactic of regulating the free market (in this case, housing) instead of insuring a growing economy, the eventual and predictable results of which were finally realized in the housing crash of 2008. We all should have known we were in trouble when housing prices began to appreciate far beyond their traditional annual rate of around 4%.

    If we had a properly educated populace, we’d take this a lesson in what not to do. In hindsight, it’s plainly evident that federal interference in the housing market got us into this mess. The entire mechanism that caused this needs to be dismantled and repealed, never to be attempted again. Always remember that what government has done, government can undo.

  3. BackwardsBoy,

    AMEN! Congratulations for having a fully functioning/reasoning brain.

    The Youtube video “Burning Down The House: What Caused Our Economic Crisis?” documents in detail with independently verifiable facts that are a matter of public record as to the cause you so succinctly expressed.

    It plays fast so the pause button needs to be used occasionally to absorb all the detail.

  4. Why have the American people not been more active in preventing this world wide mafia group from infiltrating our country – this has become such a common part of society its shocking to think there could actually be a prosecution for any kind of illegal behavior as long as the criminal maintains his status quo and connections. What effect on the prosecution of Madoff is related to his sons reporting him to the authoritites? (Blackhawk just paid 7.5 million to avoid criminal prosecution). What happened to the people who were honest, good citizens? I doubt if anyone is alive in the US with more than $250,000 portfolio is honest. This view that is so prevalent in today’s world – make money and to hell with everything else – has added to the problem and I suggest it is part of the plan to derail this once potentially great country. We are nothing but a bunch of thugs who cheat and steal and then applaud when someone lives a lavish lifestyle at the expense of all others. I ask, how can a person agree to accept millions in bonus money when there are homeless in this country? When the bonus money represents nothing concrete- nothing produced – just more abstract and dishonest behavior contributing to the spiral and of course as in nature, it will end and the men and women responsible for making this nation a country of dishonest thieves will eventually have to face their actions. In the meantime, why do Americans not make a concerted effort to stop this – to reverse it – to turn it back to the country it was meant to be – we are just a burned up crop of nothing now and we have nothing to sow but more of the same. Even trying to get away from this damned country is impossible – the crooks passed laws making even that close to impossible. Our Patriot laws are the same as Nazi Germany constitution and there is no reason for them to even be on the books – no reason for NSA to spend billions on a spy compound in Utah, and no reason for private prisons owned by a secretive and well connected group to ruin the lives of many who are not guilty while the true criminal lives a life of luxury. Is there any soul in the world who sees this is wrong and who wants to stop this direction? We face a terrible future if it is not stopped now.

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