“It took a bigger shock (than a housing bust) to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy. This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008. But raising rates is not the only route to tighter money…

…Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the “natural” interest rate — the rate that keeps the economy on an even keel — falls. By staying in place, the Fed’s target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates…. . In mid-September, shortly after the collapse of Lehman Brothers, the Fed refused to cut interest rates further, citing the risk of inflation. (To his credit, Chairman Ben Bernanke subsequently admitted that not cutting rates then was a mistake.) It did not cut rates until weeks after the crisis had become undeniable. It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008…..We could have had a decline in housing without a Great Recession. That’s what we went through for two years. What we could not have had without a Great Recession was a decline in nominal spending. If it had cut rates faster, or merely refrained from talking up future rate increases, the Fed might have kept that decline from happening or at least moderated it. Australia had a housing boom and debt bubble, too, but kept a steadier monetary policy. The consequence was a mild correction, but nothing like our Great Recession. It took decades for the Fed’s responsibility for the Great Depression to be widely accepted and it may take that long for most people to see its responsibility this time around. The Fed of 2008 feared inflation too much and recession too little. It placed too little weight on market expectations about future conditions and on how its behavior affected those expectations. If these mistakes go unrecognized, they could well be repeated.”, David Beckworth and Ramesh Ponnuru, “The Subprime Reasoning on Housing”, The New York Times, January 27, 2016

“Here’s another article showing that, with the benefit of hindsight, the “experts” at The Fed really don’t know what they are doing and often cause financial instability and economic crises. It’s way past time for Congress “to audit the Fed’s monetary policies” and probably time to require the Fed to get control of the supply of money and grow it slower and more prudently (as Nobel Laureate and monetary expert Milton Friedman long ago advised) and then let the free markets set the natural rates of interest. P.S. This article is focused on the  post-crisis Fed decisions. I am one of many, including Nobel economists, who believe that the Fed’s loose monetary policies (artificially managed rates well below the natural rate of interest) pre-crisis were the major fuel for unsustainable asset bubbles, like housing, real estate, stocks, etc. Read Mr. Friedman’s famous paper on monetary policy which I have posted on this blog. Greenspan/Bernanke/Yellen’s Fed ignores his advice and warnings.”, Mike Perry, former Chairman and CEO, IndyMac Bank

The Opinion Pages

Subprime Reasoning on Housing

By DAVID BECKWORTH and RAMESH PONNURU

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Credit Eiko Ojala

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IT has become part of the accepted history of our time: The bursting of the housing bubble was the primary cause of a financial crisis, a sharp recession and prolonged slow growth. The story makes intuitive sense, since the economic crisis included a collapse in the prices of housing and related securities. The movie “The Big Short,” which is based on a book by Michael Lewis, takes this cause-and-effect relationship as a given.

But there is an alternative story. In recent months, Senator Ted Cruz has become the most prominent politician to give voice to the theory that the Federal Reserve caused the crisis by tightening monetary policy in 2008. While Mr. Cruz (who is an old friend of one of the authors of this article) has been criticized for making this claim, he shouldn’t back down. He’s right, and our understanding of the great recession needs to be revised.

What the housing-centric view underemphasizes is that the housing bust started in early 2006, more than two years before the economic crisis. In 2006 and 2007, construction employment fell, but overall employment continued to grow, as did the economy generally. Money and labor merely shifted from housing to other sectors of the economy.

This housing decline caused financial stress by sowing uncertainty about the value of bonds backed by subprime mortgages. These bonds served as collateral for institutional investors who parked their money overnight with financial firms on Wall Street in the “shadow banking” system. As their concerns about the bonds grew, investors began to pull money out of this system.

In retrospect, economists have concluded that a recession began in December 2007. But this recession started very mildly. Through early 2008, even as investors kept pulling money out of the shadow banks, key economic indicators such as inflation and nominal spending — the total amount of dollars being spent throughout the economy — barely budged. It looked as if the economy would be relatively unscathed, as many forecasters were saying at the time. The problem was manageable: According to Gary Gorton, an economist at Yale, roughly 6 percent of banking assets were tied to subprime mortgages in 2007.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy. This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008. But raising rates is not the only route to tighter money.

Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the “natural” interest rate — the rate that keeps the economy on an even keel — falls. By staying in place, the Fed’s target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates.

Market indicators of expected inflation fell sharply that summer, a sign that the economy was getting weaker and monetary policy tighter. Nominal spending showed the change. After growing for years at a relatively steady rate, it began to drop.

In their early August meeting, some Fed policy makers nonetheless anticipated that they would raise rates soon. Inflation expectations and nominal spending kept falling. In mid-September, shortly after the collapse of Lehman Brothers, the Fed refused to cut interest rates further, citing the risk of inflation. (To his credit, Chairman Ben Bernanke subsequently admitted that not cutting rates then was a mistake.) It did not cut rates until weeks after the crisis had become undeniable.

It was against this backdrop of tighter money that the financial stress of 2007 turned into something far worse in 2008. With nominal spending falling at the fastest rate since the Depression, households, businesses and banks all had incomes lower than they had expected. That made servicing debts and paying wages harder than expected. It also lowered asset values, since those were premised on expected streams of future income.

And, of course, the crashing economy made the housing crisis worse, too. That’s why the standard account of the crisis took hold. It’s true, after all, that housing fell and then, along with the economy, plummeted. Untangling cause and effect is tricky. But the timeline is a better match for the theory that the Fed is to blame. The economy started to tank not right after housing began to fall, but right after money tightened.

We could have had a decline in housing without a Great Recession. That’s what we went through for two years. What we could not have had without a Great Recession was a decline in nominal spending. If it had cut rates faster, or merely refrained from talking up future rate increases, the Fed might have kept that decline from happening or at least moderated it. Australia had a housing boom and debt bubble, too, but kept a steadier monetary policy. The consequence was a mild correction, but nothing like our Great Recession.

It took decades for the Fed’s responsibility for the Great Depression to be widely accepted and it may take that long for most people to see its responsibility this time around. The Fed of 2008 feared inflation too much and recession too little. It placed too little weight on market expectations about future conditions and on how its behavior affected those expectations. If these mistakes go unrecognized, they could well be repeated.

David Beckworth is a former economist at the Treasury Department and a visiting scholar at the Mercatus Center; Ramesh Ponnuru is a columnist for Bloomberg View and a visiting fellow at the American Enterprise Institute.

A version of this op-ed appears in print on January 27, 2016, on page A27 of the New York edition with the headline: Subprime Reasoning on Housing

 

Posted on January 27, 2016, in Postings. Bookmark the permalink. Leave a comment.

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