Tuesday, January 12, 2010

What caused the crisis - monetary policy or regulatory failure?

The search for the villains responsible for the sub-prime mortgage bubble induced financial crisis goes on. The latest debate is over whether it was regulators who failed to regulate effectively or Fed which failed to "take the punch bowl away as the party go going".

Prof. John Taylor, of Taylor Rule fame, has claimed that the Fed erred in keeping interest rates too low for far too long after the dot com bubble burst, thereby inflating the sub-prime mortgage bubble and sowing the seeds for its subsequent disastrous consequences. He points to the sharp divergence that developed between rates as estimated by Taylor Rule and the prevailing federal funds rate since mid-2007 and the consistently low rates set by the Fed in the 2001-06 period. See the slides here.



(Based on output gap and the current rate of inflation, with inflation measured by the consumer price index (CPI), the Fed's assumed inflation target set to 2 percent, output measured by real GDP, and the output gap as estimated retrospectively by the Federal Reserve's primary forecasting model, the FRB/US model)



(Based on output gap and a forecast of inflation over the current and subsequent three quarters. The forecasts are those that were actually made in real time, that is, at the time at which the corresponding policy rate was chosen)

Rejecting Taylor's contention, in a speech (pdf here) delivered at the annual meeting of the American Economic Association (AEA), the Fed Chairman Ben Bernanke laid the blame on the failure of regulators to do their jobs effectively. He said,

"When historical relationships are taken into account, it is difficult to ascribe the house price bubble either to monetary policy or to the broader macroeconomic environment... Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates."


However, refreshingly enough, he also acknowledges that if regulation fails to get the job done, then the Fed must step in and pop bubbles before they get too large by raising interest rates. If this is the case, being a member of the Federal Reserve Board of Governors during most of the first half of the decade, Bernanke must share atleast part of the blame for going along with Greenspan's extraordinary loose money policy for the first half of the decade and his own persistence with it even as the sub-prime bubble was inflating.

As Mark Thoma points out, the Greenspan Fed believed that since it was not possible to identify with any degree of certainty bubbles as they are inflating, it was preferable to clean up after the bubble bursts. In other words, given the problems in identifying bubbles ex-ante, it was better to clean up ex-post. Further, even if it were possible to identify bubbles, interest rate increases imposes collateral damage by affecting all sectors and not just those experiencing the bubble.

It is evident that both regulators and the Fed failed, the regulators spectacularly so and they have rightly been blamed across the board. But the Fed and Bernanke have clearly gotten away lightly, and even been rewarded for preventing a slide into Depression. It is well documented that by 2007 there were enough indications that a very large bubble was getting inflated in the real estate market and there was considerable misallocation of resources among the financial market participants (short term debt, leverage etc). It does not require the wisdom of hindsight to see "bubble" staring out from all the credit and money market indicators, leave alone individual bank balance sheets and risk ratios. If not earlier, atleast then, the Fed should have blown the whistle and raised rates to deflate the bubble slowly.

Barry Ritholtz argues that while the regulations were inadequate and existing ones were not properly enforced, the fact remains that the ultra-low interest rate policy of the Fed had already set in motion an unhealthy scramble for yields. Mark Thoma makes the point that the failures were broad-based, with all the gate-keepers failing repeatedly on their duties. He writes,

"Home buyers, real estate agents, appraisers, mortgage brokers, securitizers, ratings agencies, compensation packages of executives, lack of transparency, and so on and so on all broke down and allowed the housing/credit bubble to inflate. If any one of these groups had held the line and not gone along with everyone else, e.g. if appraisers had not reported bubble prices, if ratings agencies had priced risk correctly, etc., then the bubble either doesn't happen at all, or does much less damage when it pops."


Update 1
Mark Thoma feels that the "bubble itself was driven by 'cash slopping around in the system' that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage".

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