Federal reserve policy and the housing bubble.

• Author: White, Lawrence H.

The U.S. housing bubble and the fallout from its bursting are not the results of a laissez-faire monetary and financial system. They happened in an unanchored government fiat monetary system with a restricted financial system.

What Happened and Why?

Our current financial turmoil began with unusual monetary policy moves by the Federal Reserve System and novel federal regulatory interventions. These poorly chosen public policies distorted interest rates and asset prices, diverted loanable funds into the wrong investments, and twisted normally robust financial institutions into unsustainable positions. There is no doubt that private miscalculation and imprudence have made matters worse for more than a few institutions. Such mistakes help to explain which particular firms have run into the most trouble. But to explain industry-wide errors we need to identify price and incentive distortions capable of having industry-wide effects.

Here I will make two main points. First, the Federal Reserve's expansionary monetary policy supplied the means for unsustainable housing prices and unsustainable mortgage financing. Elsewhere (White 2008) I have discussed the growth in regulatory mandates and subsidies that exaggerated the demand for riskier mortgages, most importantly the implicit guarantees to Fannie Mae and Freddie Mac that combined with HUD's imposition of "affordable housing" mandates on Fannie and Freddie to accelerate the creation of a market for securitized subprime mortgages. (1) Second, the Federal Reserve has undertaken self-initiated new lending roles that constitute a shadow bailout program more than twice the size of the Treasury's $700 billion bailout program. There is unfortunately little evidence that the Fed's new lending has helped to resolve our financial problems, rather than to delay their resolution.

The Credit Supply Bubble

Some authors, considering the relationship of Federal Reserve policy to asset bubbles, ask only: Should the Fed actively burst a growing bubble? If so, how? As posed, their questions suggest that asset bubbles arise independent of monetary policy, and the only Fed role to be discussed is that of bubble-buster. A more important pair of questions is: Does Fed policy as currently conducted tend to inflate assets bubbles? If so, how can we reformulate policy to avoid that tendency? Call our objective a non-bubble-prone or "non-effervescent" monetary policy. The economics profession has not reached a consensus on what the optimally non-effervescent monetary policy is, but it is now widely agreed that it isn't holding interest rates too low for too long. It should also now be clear that a Fed policy that deliberately ignores asset prices, as though consumer prices alone were a sufficient indicator of excessive Fed expansion, is also not the way to avoid inflating asset bubbles.

In the recession of 2001, the Federal Reserve System under Chairman Alan Greenspan began aggressively expanding the U.S. money supply. Year-over-year growth in the M2 monetary aggregate rose briefly above 10 percent, and remained above 8 percent entering the second half of 2003. The expansion was accompanied by the Fed's repeatedly lowering its target for the federal funds (interbank overnight) interest rate. The Fed funds rate began 2001 at 6.25 percent and ended the year at 1.75 percent. The Greenspan Fed reduced the rate further in 2002 and 2003, pushing it in mid-2003 a record low of 1 percent, where it stayed for a year. The real Fed funds rate was negative--meaning that nominal rates were lower than the contemporary rate of inflation--for an unprecedented two and a half years. A borrower during that period who simply purchased and held vacant land, the price of which (net of taxes) merely kept up with inflation, was profiting in proportion to what he borrowed.

How do we judge whether the Fed expanded more than it should have? One venerable (albeit no longer popular) norm for making fiat central bank policy as neutral as possible toward the financial market is to aim for stability (zero growth) in the volume of nominal expenditure. In the equation of exchange, MV=Py, nominal expenditure is MV or equivalently Py. Stability of MV implies that the Fed should not inject money through the financial market to offset growth in real output (y) due to increasing productivity. Instead it should allow consumer goods prices to fall when productivity gains reduce the costs of production (see Selgin 1997). Second-best to stability of nominal expenditure would be a predictably low and steady growth rate. One useful measure of nominal expenditure is the dollar volume of final sales to domestic purchasers (GDP less net exports and change in business inventories). During the two years from the start of 2001 to the end of 2002, final sales to domestic purchasers grew at a positive but moderate compounded rate of 3.6 percent per annum. During 2003 the Fed's expansion of demand began to show up: the growth rate jumped to 6.5 percent. For the next two years, from the start 2004 to the end of 2005, the growth rate was even higher at 7.1 percent, nearly a doubling of the initial rate. It then backed off, to 4.3 percent per annum from the start of 2006 to...