“There is an Interaction Between The Monetary Excesses (by the Fed) and Risk-Taking Excesses; Rapidly Rising Housing Prices and Resulting Low Delinquency Rates Threw Underwriting Programs Off Track…”, John B. Taylor

Mr. Bernanke: “Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say?”

Mr. Taylor (“of the Taylor Rule”): “Figure 1 shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period (2002 – 2005), or too ‘loose fitting’, as the ‘The Economist’ puts it. This deviation from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s.

“Who is right here? Mr. Taylor’s arguments make sense to me and are backed by empirical data. Mr. Bernanke’s comments to the FCIC are not under oath and while I found them to be generally very forthcoming and accurate, I have noted on this blog I felt his FCIC comments re. Fed monetary policy/interest rates were not. I believe they were designed to protect the Fed. Read the excerpts below from Mr. Taylor’s book and from Mr. Bernanke’s 2009 conversation with the FCIC below and decide for yourself. Mr. Taylor’s book has been lauded by famed monetary economist Anna Schwartz, and former Secretary of Treasury; State, and Labor George P. Shultz.” Mike Perry, former Chairman and CEO IndyMac Bank

Key Excerpts from John B. Taylor’s “Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis (John B. Taylor is a Senior Fellow at the Hoover Institution and Professor of Economics at Stanford University):

 “What caused the financial crisis? What prolonged it? What worsened it dramatically more than a year after it began? Rarely in economics is there a single answer to such questions, but the empirical research I present in this book strongly suggests that specific government actions and interventions should be first on the list of answers to all three.”

What Caused the Financial Crisis

“I begin by showing that monetary excesses (Fed policies) were the main cause of that boom and the resulting bust.”

“Figure 1 shows that the actual interest-rate decisions fell well below what historical experience would suggest policy should be. It thus provides an empirical measure that monetary policy was too easy during this period (2002 – 2005), or too ‘loose fitting’, as the ‘The Economist’ puts it. This deviation from the Taylor rule was unusually large; no greater or more persistent deviation of actual Fed policy had been seen since the turbulent days of the 1970s.”

“The unusually low interest-rate decisions were, of course, made with careful consideration by monetary policy makers. One could interpret them as purposeful deviations from ‘regular’ interest-rate settings….Those actions were thus essentially discretionary government interventions in that they deviated from the regular way of conducting policy in order to address a specific problem, in particular the fear of deflation, as had occurred in Japan in the 1990s.”

“In presenting this chart to the central bankers in Jackson Hole in the later summer of 2007, I argued that this extra-easy policy accelerated the housing boom and thereby ultimately led to the housing bust. Others made similar arguments. The Economist magazine wrote, in the issue then on the newsstands, ‘by slashing interest rates (by more than the Taylor rule prescribed) the Fed encouraged a house-price boom. To support the argument empirically, I provided statistical evidence showing that the interest-rate deviation in Figure 1 could plausibly bring about a housing boom….In this way I provided empirical proof that monetary policy was a key cause of the boom and hence the bust and the crisis.”

“Although the housing boom was the most noticeable effect of the monetary excesses, the effects could also be seen in more gradually rising overall prices: inflation based on the CPI average 3.2 percent annually during the past five years, well above the 2 percent target.”

“The more systemic monetary policy followed during the Great Moderation had the advantages of keeping both the overall economy stable and the inflation rate low.”

“Some argue that the low interest rates in 2002-4 were caused by global factors beyond the control of the monetary authorities. If so, then interest-rate decisions by the monetary authorities were not the major factor causing the boom…..It argues that there was an excess of world saving…a global saving glut…..that pushed interest rates down in the United States and other countries. The main problem with this explanation is that there is no actual evidence of a global savings glut….As implied by simple global accounting, there is no global gap between saving and investment.”

“Nevertheless there are possible global connections to keep track of when assessing the root cause of the crisis. Most important is evidence that interest rates at several other central banks also deviated from what historical regularities, as described by the Taylor rule, would predict. Even more striking is that housing booms were largest where the deviations from the rule were the largest….The country with the largest deviation from the rule, Spain, had the biggest housing boom, measured by the change in housing investment as a share of GDP.”

“One important question, with implications for reforming the international financial system, is whether the low interest rates at other central banks were influenced by the decisions in the United States or represented an interaction among central banks that caused global short-term rates to be lower than they otherwise would have been…..Figure 5 shows how much of the ECB’s interest-rate decisions could be explained by the Fed’s interest-rate decisions. It appears a good fraction can be explained this way…By this measure, the ECB interest rate was as much as 2 percentage points too low during this period. The smoother line shows that a good fraction of the deviation can be ‘explained’ by the federal funds rate in the United States….Indeed it is difficult to distinguish statistically between the ECB following the Fed and the Fed following the ECB..”

Monetary Interaction with the Subprime Mortgage Problem

 “A sharp boom and bust in the housing markets would be expected to affect the financial markets, as falling housing prices led to delinquencies and foreclosures. Those effects were amplified by several complicating factors, including the use of subprime mortgages, especially the adjust-rate variety, with led to excessive risk taking. In the United States such risk taking was encouraged by government programs designed to promote home ownership, a worthwhile goal but overdone in retrospect.”

“During 2003-5, when short-term interest rates were still unusually low, the number of adjustable-rate mortgages (ARMs) rose to about one-third of total mortgages and remained at that high level for an unusually long time. This made borrowing attractive and brought more people into the housing markets, further bidding up housing prices.”

“It is important to note, however, that the excessive risk taking and the low-interest monetary policy decisions are connected…Observe in Figure 6 how delinquency rates and foreclosure rates were inversely related to housing price inflation during this period. In the years of rapidly rising housing prices, delinquency and foreclosure rates declined rapidly. The benefits to holding onto a house, perhaps by working longer hours to make the payments, are higher when the price of the house is rapidly rising. When prices are falling, the incentives to make payments are much less and turn negative if the price of the house falls below the value of the mortgage. Hence, delinquencies and foreclosures rise.”

“Mortgage underwriting procedures are supposed to taking into account actual foreclosure rates and delinquency rates in cross-section data. These procedures, however, would have been overly optimistic during the period when prices were rising….Thus, there is an interaction between the monetary excesses and risk-taking excesses. This illustrates how unintended things can happen when policy deviates from the norm.”

“In this case, the rapidly rising housing prices and the resulting low delinquency rates likely threw the underwriting programs off track….”

More Complications: Complex Securitization, Fannie, and Freddie

“These problems were amplified because adjustable-rate subprime and other mortgages were packed into mortgage-backed securities of great complexity. The rating agencies underestimated the risk of these securities because of a lack of competition, poor accountability, or, most likely, and inherent difficulty in assessing risk due to the complexity.”

“The risk in the balance sheets of financial institutions has been at the heart of the financial crisis from the beginning.”

“In the United States other government actions were at play. The government-sponsored agencies Fannie Mae and Freddie Mac were encouraged to expand and buy mortgage-backed securities, including those formed with risky subprime mortgages. Although legislation, such as the Federal Housing Enterprise Regulatory Reform Act of 2005, was proposed to control those excesses, it was not passed into law. Thus the actions of those agencies should be added to the list of government interventions that were part of the problem.”

Monetary Policy Excerpts from Chairman of the Federal Reserve Ben Bernanke’s Closed Session on November 17, 2009, before the Financial Crisis Inquiry Commission:

Mr. Bernanke: “The third explanation, which I’m sure you’ll investigate, has to do with monetary policy in 2003, 2004, 2005. Interest rates were down to 1 percent during that period for the reasons having to do with both the slow recovery from the recession and because of concerns about deflation at the time.”

Mr. Bernanke: “Some have argued…and I’m sure you’ll look at it…that those low rates contributed to the risk-taking….I think there are a lot of different components of this issue….if I could just sort of illustrate why there are a number of different questions to be looked at. The first question is, was, in fact, this policy (monetary) the cause or a major cause? And as I have said, there are some alternative hypothesis, like the saving glut and some other things. A second question is, if it was a cause, you know, was it a knowable problem? Was the Fed doing the best it could give the information it had, or was it neglecting information it should have used?…And related to that is the general issue, which has become very hot in monetary circles, which is, should monetary policy be used to try to know down bubbles or not?”

Mr. Bernanke: “Even if you believe that the Fed’s monetary policy was a contributor to the bubbles, it should be noted that even people who are most critical of the Fed’s policy acknowledged that it was only….it was not a large mistake. It was a percentage point or two relative to, say, what the Taylor rule, which is the standard measure of interest rate policy is…if you have a situation where a relatively small mistake…if it was a mistake, I’m just accepting that hypothesis…leads to the biggest financial crisis since World War II, I mean, what does that say? They say that the system itself was inherently unstable and that a relatively small shock was enough to knock it off the pedestal.”

Mr. Bernanke: “I think the Fed…the Fed made some mistakes. But I think the current attitude in Congress that somehow the Fed is now the scapegoat, I think that’s quite unfair. The Fed, I don’t think that our interest-rate policy was a big source of the problem, both because I don’t think it was obviously the wrong policy, and also because, again, as I said, if the system hadn’t been incredibly fragile, you know, it wouldn’t have caused anything.”

Posted on September 26, 2013, in Postings. Bookmark the permalink. Leave a comment.

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