The fallacy of a stricter fed.

• Author: Gokhale, Jagadeesh
• Position: Federal Reserve System - Business & Finance

"Imposing onerous financial regulations only will impede the reconstitution of financial institutions, delay the recovery, and dampen the pace of long-term economic growth."

A NUMBER of commentators have argued that if the Federal Reserve had followed a stricter monetary policy when the housing bubble was forming, and if Congress had not deregulated banking but had imposed tighter financial standards, the housing boom and bust--and the subsequent financial crisis and recession--would have been averted. They specifically point to a pair of supposedly important causes for today's financial woes: inappropriately loose monetary policy during 2003-05 and financial market deregulation, including the 1999 Gramm-Leach-Bliley banking reform act (GLB), the lack of regulation of credit default swaps, and loose capital and leverage standards. The contention basically is that tighter Federal Reserve policy and stricter capital market regulation would have averted the crisis and should be adopted now to avoid future crises.

We dispute those claims. We are skeptical that economists can detect bubbles in real lime through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy. Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.

Critics also have contended that the popularization of financial products--such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors--is to blame for the financial crisis. We find little evidence for this. Housing data indicates that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, theft execution through a clearinghouse or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

In short, the many policy proposals that advocates on the left and right now say are necessary because of the financial crisis--such as stricter regulation of derivatives and banking, higher reserve requirements, and more conservative Fed policy--would have done little to avert the financial crisis. The crisis simply is the product of the widespread belief that residential real estate investment is "safe as houses," and it is unclear what policy could have disabused both policymakers and financial markets of a firmly held, but false, belief.

It is claimed that an essential component of any policy to prevent future financial crises and their negative effects on the real economy is the detection of asset-price bubbles. For such a policy to be successful, economists must be able to use the technical tools of the discipline to distinguish sustainable from unsustainable asset appreciation in real time and inform decisionmakers about appropriate policy responses. We believe that the track record of forecasts during the recent housing-price bubble suggests that such a faith in the ability of technical analysis to reveal "the correct" answer is unwarranted. If so many economists could not foresee the danger posed by the housing bubble, then it seems unclear how any new policy empowering such economists to steer the nation away from future crises will be effective.

Even if these economists clearly had identified the threat of runaway housing prices, Fed officials charged with preventing asset-price bubbles may have continued to insist that no policy action to counter the bubble was warranted because so many other factors made deflation an overriding concern. During the early 21st century, the Fed had investigated the implications of a deflationary environment. Under such conditions, with rising real debt burdens and slowing economic activity, monetary policy would be rendered impotent because a low Federal funds rate could not be reduced below zero percent. That is, with price levels nearly stagnant and at risk of sliding backwards, the Fed would be unable to lower interest rates in order to spur the economy.

Conventional inflation measures were very low during this time period. Growth in the Consumer Price Index and Personal Consumption Expenditures Price Index remained close to zero between 2001 and 2005, with the CPI growth occasionally wandering into negative territory. Thus, deflation--not inflation--was of primary concern.

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If lax monetary policy was the chief cause of the housing bubble, then higher rates would have been the solution. What is the evidence that higher Federal funds rates during the early 21st century would have prevented the housing bubble from developing? According to Alan Greenspan, former chairman of the Federal Reserve, homes are long-lasting assets and are priced based on long-term interest rates. Whatever the power of the Fed to influence short-term rates, long-term rates have not followed the short-rates since the mid 1990s, making monetary policy--to the extent it could influence the term structure of interest rates--relatively ineffective in influencing the opportunity costs of housing finance.

Gerald O'Driscoll Jr., a former vice president at the Federal Reserve Bank of Dallas, argues that the subprime and low-teaser-rate mortgages used in the boom-and-bust areas of California, Florida, Arizona (the Phoenix area) and Nevada (the Las Vegas area) are priced based on much shorter-term rates of one to three years because these mortgages are funded by short-term borrowing. As a result, he suggests that Greenspan's focus on the relationship between Fed policy and long-term rates is irrelevant.

However, even short-term mortgage rates were decoupled from short-term--Federal...