Ben Bernanke may minimise the role of monetary policy in the housing debacle, but he minimises two key factors; the effect low rates and the Fed's policy of cleaning up after but not popping bubbles had on risk-taking.
In what amounts to a defence of his own and Alan Greenspan's legacy, Bernanke maintains that low interest rates didn't cause the bubble, which he says required a regulatory rather than monetary solution.
"Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages," Bernanke said in Atlanta over the weekend. (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm)
And where, I wonder, did borrowers get the idea that these new-fangled mortgages were good for them and that double-digit house price increases would continue? Greenspan famously sang the praises of mortgage innovation and floating rates for house buyers, while both he and Bernanke missed the bubble and downplayed its potential impact almost all the way to the bottom.
Even more to the point was the Fed's asymmetrical response to bubbles: doing nothing to pop them on the way up, and dropping rates to ease the pain in their aftermath. So the Fed did after the dot-com crash and so it did again, in spades, after the housing bust.
The Fed under Greenspan, who seemed to believe that markets were not just efficient but somehow magical and whose direction of monetary policy during his term was largely consistent with that point of view, allowed the bubble to form. No amount of retro-fitting the Taylor rule on different variables will change that. Bernanke acknowledges he might be forced to use the blunt force of interest rates against future housing bubbles, but his speech seems designed to leave the reader with the impression that higher rates are a last worst choice.
It's not "what can I afford?", it's "what can I earn?"
So it seems Greenspan's asymmetry has been made a bit more even by Bernanke, though given the experience of the last few years, that is pretty scary. The incentives and attitudes, at least toward financial innovation, are still there and so is the belief that the Fed will be there to ease the pain if another bubble pops.
Bernanke makes the argument that the effect of lower rates pales in comparison with the impact of products that defer payments or allow borrowers to keep payments lower in exchange for taking more risk.
I think it's not hard to argue that the Federal Reserve, as an interest rate setting body, had a bigger impact on house prices during the brave new world period of heavy securitisation than perhaps it had when Fannie, Freddie and their non-government-backed competitors were smaller.
But it's important to understand that this impact had at least two important parts. The first Bernanke addresses; low interest rates as an enabler for house buyers who might not otherwise be able to reach for a given house. But the second is at least as important. Low interest rates almost certainly had a huge impact on the providers of capital, especially those providers of capital to the financial markets, as opposed to traditional bank financing of mortgages.
"What Bernanke seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world's bond managers," Barry Ritholz, CEO and director of equity research at research firm Fusion IQ in New York, wrote on his blog http://www.ritholtz.com/blog/>.
Those people, and I know because I was interviewing them throughout the period, were reaching for yield. They had badly thought out targets that had been put together during periods of higher inflation and they wanted to be able to meet them still despite a low overall rate structure.
That unmet need – for an eight per cent return in a three per cent world – was met magically but only temporarily by structured finance. Is that the fault of low interest rates? Not strictly speaking, but it is in substantial part the fault of the Fed, which wrote cheap insurance for risk takers, praised their innovations and cleaned up after their messes.
Low rates in a world of asymmetrical monetary policy are all the more potent and all the more dangerous.
Still, better regulation is called for and without it higher rates in isolation would be dangerous and destructive. Based on Bernanke's speech, I am not guessing that we will get either effective regulation or preemptive interest rate rises.
The practical implication, for those of you interested in more than who is to blame, is more bubbles.
- The writer is a Reuters columnist. The opinions expressed are his own
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