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If there is one man in the nation's capitol who
maybe isn't too unhappy about Treasury Secretary Tim Geithner being in the news today, it's probably Fed Chairman Ben Bernanke who
delivered a speech titled Monetary Policy and
the Housing Bubble over the
weekend, a topic that continues to generate a lot of discussion at mid-week,
little of it positive.
In what clearly appears to be an attempt to work
backwards from a conclusion (based on its contents, a better title for the
speech would have been "Monetary Policy was not Responsible for the
Housing Bubble"), the Fed chairman demonstrates an incredible
lack of understanding about the financial and political world in which he
lives and exhibits some disturbing character flaws that have not been on
display before to this degree, namely, a dangerous reliance on economic models
and a disingenuous use of the English language to sway public opinion.
So as not to repeat what others have already written about a speech that, one
day, will probably rival (if not exceed) in ignominy the Fed chairman's
"helicopter speech" from early in the last decade, a brief recap of
others' observations is in order.
But, before even that, it is worth noting that, in a sign of how quickly
things may be changing for the central bank chief, Google now finds more
matches when the current Fed Chairman's name
is combined with the word "failure" than when using the former Fed Chairman's name:
Whether the relationship between these two has
changed in recent days as a result of this speech is not known, but, on its
face, it is surely not a good omen and bears close watching as the Fed
chairman's confirmation vote in the full Senate approaches.
Early on Monday, Barry Ritholtz at The Big
Picture argued that bond managers reaching for yield
due to record low short-term interest rates was a direct consequence of
monetary policy, one of many factors that contributed to the financial market
meltdown.
What Bernanke seems to be overlooking in his exoneration of ultra-low
rates was the impact they had on the world’s Bond managers —
especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on
the demand for higher yielding instruments, like securitized
mortgages (Yes, I laid all this out in the book).
Barry then supplied a ten step causation timeline
that began with low yields and ended with a collapsed credit system, touching
upon mortgage backed securities, ratings agencies, and derivatives along the
way, reinforcing the point that step one was "lower interest
rates", not "beef-up regulation", what we know now is a recipe
for disaster.
The failure of effective regulation was the key to the systemic failure in
Bernanke's view, however, John Carney at ClusterStock took issue with this line of thinking.
Bernanke makes the extraordinary claim that regulatory and supervisory
policies would have been effective means of addressing the run up in housing
prices. What makes this claim so extraordinary is that it completely ignores
the fact that regulatory and supervisory policies weren’t just
ineffective at popping the housing bubble—they were actively fueling it.
...
This is why Bernanke’s view is so disturbing. He
urges “stronger regulation” but shows no awareness of the
culpability of regulations for the bubble. Or, more charitably, he
only acknowledges that the regulatory response was inadequate rather than
wrong headed.
The claim that better regulation will prevent this
from happening next time (or, now, since rates are even lower today than in
2003), reminds me of former Fed chief Alan Greenspan's oft-cited remedy for restoring
American competitiveness in the world when queried on the subject during
Congressional hearings - better education.
Better regulation is the financial word's Holy Grail just as better eduction
is the unachievable goal for elected officials who promise their constituents
that their children's lives will be as good as their own (we seem to have
long since given up on "better than their own").
I don't know. I suppose that if I were the Fed chairman and set out to defend
the central bank and its policies, this would be the approach that I would
take too. Otherwise it brings into question the very nature of the last 50
years of higher education in economics.
As for higher learning in the dismal science and the vaunted economic
"models" that seem to have failed so badly in recent years,
Caroline Baum at Bloomberg noted that Bernanke's defense of monetary
policy even had to take liberties with that.
Bernanke takes great pains to rebut criticism that the funds rate was
well below where the Taylor Rule, developed by Stanford economist John
Taylor, suggested it should be following the 2001 recession. The Taylor Rule
uses actual inflation versus target inflation and actual gross domestic
product versus potential GDP to determine the appropriate level of the funds
rate.
Substitute forecast inflation for actual inflation, and the personal consumption
expenditures price index for the consumer price index, and -- voila! -- monetary policy looks far less accommodating,
Bernanke said.
It shouldn't be too surprising that the co-creator
of the Taylor Rule wasn't too happy about all of this. According to this
Reuters report, Taylor said, “The
evidence is overwhelming that those low interest rates were not only
unusually low but they logically were a factor in the housing boom and
therefore ultimately the bust” .
Well, apparently, if something doesn't exist in the Fed's models (however
they might be tortured and twisted to produce the desired answer), then it
can't exist in the real world, and that is what, in my view, was most
disturbing about Bernanke's speech - the nearly blind reliance on models
that the Fed creates.
This is best demonstrated by the following excerpt and graphic:
With respect to the magnitude of house-price increases: Economists who
have investigated the issue have generally found that, based on historical
relationships, only a small portion of the increase in house prices earlier
this decade can be attributed to the stance of U.S. monetary policy. This conclusion has been reached using both econometric models
and purely statistical analyses that make no use of economic
theory.
To demonstrate this finding in a simple way, I will use a statistical model
developed by Federal Reserve Board researchers that summarizes the historical
relationships among key macroeconomic indicators, house prices, and monetary
policy ... For our purposes, the value of such a model
is that it can be used to predict the behavior of any of the variables being
studied, assuming that historical relationships hold and that the
other variables in the system take on their actual historical values.
Slide 6 illustrates the application of this procedure to the federal
funds rate and housing prices over the period from 2003 to 2008. In the left
panel of the figure, the solid line shows the actual history of the federal
funds rate. The shaded area in the figure is constructed using the results of
the statistical model; it shows the range of possible outcomes that would be
considered "normal" for the federal funds rate, assuming that the
other six variables included in the model took their actual values during the
years 2003 through 2008. Values of the federal funds rate that fall in the
shaded area are relatively "close to" (technically, within 2
standard deviations of) the corresponding forecast values. In line with our
earlier discussion, the left panel of the figure suggests that, although
monetary policy during the period following the 2001 recession was
accommodative, it was not inconsistent with the historical experience, given
the macroeconomic environment of the time.
The right panel of the figure shows the forecast behavior of house prices
during the recent period, taking as given macroeconomic conditions and the
actual path of the federal funds rate. As you can see,
the rise in house prices falls well outside the predictions of the model.
Thus, 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.
In short, since the models
prepared by the Fed economists indicate that short-term rates were at the
right level, they had to have been correct.
Moreover, the models still don't show a
housing bubble and, therefore, it can't be the fault of the economists that
they missed it, the very idea that "correct" monetary policy was
somehow involved in the financial crisis now probably being viewed as
preposterous and, perhaps, a running joke amongst the central bank's deepest
thinkers.
Can there be a more disappointing revelation about the state of contemporary
economics?
Bernanke goes on to suggest that "changes in the
methods of mortgage finance" may be involved somehow in the
failure of their models to see the housing bubble in advance, but, that
neatly turns back into a question of regulation, the failure of the
collective foresight of hundreds of PhD economists and their
"models" quickly forgotten.
The one thing that has always bugged me about the dismal science is that far
too many of its practitioners fail to pull their noses up out of their
textbooks, theories, and models long enough to look at what is happening in
the real world.
Alas, even if they did, it's not clear if they would have even recognized the
many dangers that were so obvious to so many of us back in the early part of
the decade that just concluded.
Lastly, the part about this speech that has compelled me to seriously
consider changing the text below the title of my humble little blog (as
readers have been urging me to do for a few years now) from:
The Mess That Greenspan Made
HOW 18 YEARS OF EASY
MONEY CHANGED THE WORLD
to
The Mess That Greenspan Made
AND THAT BEN BERNANKE IS
MAKING EVEN WORSE
can be found toward the end of the speech, just at
the beginning of the section on conclusions and policy recommendations:
House prices began to rise in the late 1990s, and although the most
rapid price increases occurred when short-term interest rates were at their
lowest levels, the magnitude of house price gains
seems too large to be readily explainable by the stance of monetary policy
alone.
Now, this is a common little trick that many writers
(including myself) use when they want to state something emphatically but, in
their heart of hearts, might not really believe it and, more importantly,
don't want to go that far out on a limb anyway for fear of it coming back to
haunt them. Some people are masters at this and, sometimes, you really have
to pay close attention to little words that are inserted into sentences, such
as the word 'alone' above.
Without that little word, the meaning changes entirely.
But, when that little word is included, the
writer can always claim that he never said something that most people believe
that he did say and, while this may be a
trivial issue for most matters, it is very
important when decades of economic theory are being questioned as never
before and the future of the global economy hinges on whether or not low
interest rates played a key role in the 2008 financial market crash.
Tim Iacono
Iacono Research.com
Tim Iacono is the
founder of Iacono Research which provides market commentary and investment
advisory services specializing in macroeconomic analysis and commodity based
investing. He also writes the popular blog The Mess That Greenspan Made.
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