Was It Interest Rates?

One of the enduring myths about the banking implosion is that the real estates bubble was facilitated in part, or in main, by the incredibly lax monetary policy started by Alan Greenspan and then continued by Ben Bernanke. This story goes like this: interest rates were keep much too low for much too long during the years after the 2001 recession, partly in response to the recession and partly in response to the bursting of the hi-tech bubble. These low rates flooded the markets with liquidity and encouraged steadily increasing risk taking. The end result being the burgeoning of the sub-prime mortgage business which, in the eyes of the analysts pressing this line of reasoning, became the cause of the crisis.

One piece of evidence often used in arguing this case is the so-called Taylor rule I have mentioned here before. The Taylor rule is a ‘rule of thumb’ calculation that correlates the goals of the Fed – managing inflation and unemployment – with an appropriate interest rate. For those of you who have read more about these things the Taylor rule recalls the relationships we all used to see in the ‘Phillips curve’ of yore. The Taylor rule suggested a level of rates a good 3% higher than those actually implemented by the Fed for long stretches from 2001 onwards. This gap between what the rule suggested and what rates actually were is the ‘smoking gun’ that purportedly damns the Fed.

My issue with this is that it ignores so much else.

While I agree that the Fed kept rates too low for a long time and thus missed an opportunity to throttle the bubble before it collapsed on us, I am no longer sure we can simply point at the Fed and ignore everything else.

The banks, for instance, were surely complicit. There is nothing in the Fed keeping interest rates too low that forces a bank to throw caution to the wind and abandon sensible loan underwriting policies. Lax standards at the banks are a much more likely cause of the bubble than rates.

Then why didn’t the profit motive, that old ‘market magic’, prevent the banks from being stupid? After all Alan Greenspan’s extraordinary naivety was based upon a faith that the market would identify and compensate for any foolish or overly risky activities. Instead the entire market went over the cliff, lemming like, at the same time. Far from acting as a balancing and purging force the market accelerated and hyped up the failure. This was an epic example of a ‘market failure’ – something that free market exponents have always told us cannot happen.

And this is why we see the blame shifted to the Fed.

The free market advocates deny that markets could be so insane as to allow an asset bubble to occur. Indeed Eugene Fama of the University of Chicago, and the inventor of the Efficient Markets Hypothesis we find at the center of the failed risk management models the banks used, still denies that a bubble even existed. So such people have to look for an alternative cause and, being ideologically so predisposed, they point to the government.

They actually point to two government errors:

First is the low rate environment of the Fed. Second is the social tinkering in real estate and the obsessive desire of American governments to encourage home ownership. This second cause found, according to the likes of Fama, its manifestation in the over funding of Fannie Mae and Freddie Mac, and in the continuation of the tax break given to home owners who use debt to buy a home. To Fama, if the government had not tried to skew the market towards home ownership there would have been no crisis.

I agree. Well in part. Clearly the government’s continuous support of home owners at the expense of renters does produce an over investment in housing. This inflates home prices because it encourages people who might otherwise rent to buy a home – the government is subsidizing ownership and not renting. So the number of people buying homes is artificially inflated and prices are forced up by this ‘excess’ demand. Abolishing the tax credit for mortgage interest would not just help close the budget deficit – it is one of our most expensive welfare programs – but it would lower home prices.

But what about market efficiency?

Should markets not adjust for this?

The rational expectations hypothesis of Fama’s colleague Robert Lucas tells us that consumers are rational enough to realize, and adjust to, distortions they see the government introducing. This is why Lucas argues against any government intervention and is such an ardent opponent of Keynsian style stimulus. [Lucas won the Nobel prize for this work]

So what happened?

The free market crowd cannot have it both ways. They cannot argue, as Lucas and Fama do, that it was all the government’s fault, and then turn around and argue that stimulus won’t work because the market won’t be fooled by it. I have to ask: why was the market fooled at all? By those low rates for instance?

The problem is much less complicated if, like me, you are more skeptical about markets than Fama and Lucas are. I prefer Minsky’s interpretation of Keyne’s basic theory: markets can and often do wander away from a balance or equilibrium position. They are often inefficient and absorb information poorly. They are prone to excess and crisis. Bubbles are a frequent and natural result of this inefficiency.

Minsky’s ‘Financial Instability Hypothesis’ stands far more justified by recent events than Fama’s Efficient Markets Hypothesis. This is a resounding defeat for the Chicago school of thought, the legacy of Milton Friedman, in economics, and brings to an end a very divisive chapter in the history of economic theory. Keynes has been rehabilitated from the temporary victory won by Friedman and his ‘monetarist’ colleagues and the subsequent ‘New Classical’ theory developed mainly at Chicago.

The irony of this was summed up well by Greg Mankiw, a Harvard professor and sometime advisor to George Bush, who wrote in 2006 that most of economic theory developed since 1970 has proven to be useless at best and damaging to public policy at worst. Mankiw is a Keynsian of sorts and so probably delights in the travails of the Chicago school.

For the rest of us: we see the conflict over economic theory form the outside. It manifests itself in this discussion over the role of the Fed. If you are a New Classicist and believe in market magic then the Fed must be at fault since the market is always correct. If you are a Keynsian you can be more ecumenical and so can spread the blame around.

It wasn’t just the Fed. The private sector went insane as well. The market failed.

Which is why we need to set up new rules and boundaries to stop a repeat. This is the basis for the re-regulation argument. Since markets can and do go wrong, it is socially less expensive, and very wise, to limit the extent of the market by hemming in the players with institutional rules. We call those rules ‘regulation’. The people who are regulated see it all as unnecessary government tinkering and red tape. Taxpayers should see it as insurance to limit the cost of the next bail out.

And, yes, we will need another bail out. Markets go wrong. That means banks will need help. Regulations are designed to reduce the cost of that next bail out.

So it wasn’t just interest rates.