Ben Bernanke says Federal Reserve interest rate policy after the dot.com bubble burst did not cause the housing bubble, and he delivers a strong rebuttal to John Taylor on that point. He argues the problem was with the regulation of these markets, not the low interest rates after the dot.com crash, and based upon this reading of the causes of the crisis, he believes regulation is the key to preventing bubbles. But 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 (though doubts are expressed about whether increasing interest rates would have done much to stop the bubble, hence the strong preference for regulatory solutions).
This is a big step forward relative to the Greenspan years. Greenspan argued that the Fed could not identify bubbles as they are inflating with sufficient clarity to allow policy to do much about them, he thought the Fed was as likely to do harm from raising interest rates based upon false bubble alarms as it was to prevent problems. And in any case, he believed that cleaning up after bubbles popped would be enough to avoid large downturns like we are experiencing. The best that the Fed could do given the difficulty in identifying bubbles ex-ante is to clean up after they self-identify by popping, but that would be more than enough to keep the economy from experiencing big crashes.
Greenspan's view that cleaning up ex-post would be sufficient to insulate the economy from large shocks turned out to be incorrect. He also resisted and actively dismissed regulatory interventions intended to keep the financial sector stable and keep bubbles from inflating in the first place, and this, too, was a mistake. In the past, Bernanke and other members of the Fed have also been resistant to using interest rate policy (as opposed to regulation) to prevent bubbles, so this is an evolution in the Fed's view of its role in preventing asset price bubbles from threatening the stability of the broader economy.
The Fed still strongly prefers regulatory solutions, the main problem with interest solutions are that bubbles are hard to identify, and even if you do identify them, interest rate increases affect all industries, not just the one experiencing the bubble, so the policy inflicts collateral damage (though perhaps less collateral damage than if the bubble actually pops). In this regard, I wish Bernanke would have talked about how the Fed might find better measures of growing financial market imbalances, measures that would allow it to better identify bubbles a priori. We can use interest rate and regulatory policy to fight bubbles much better and target policy more precisely if we have more certainty about the existence of bubbles as they are inflating, but that will require the Fed to develop much better measures of financial market fragility than it now has. (This is an alternative to incorporating asset prices into the index the Fed targets through its implicit Taylor rule, something that automatically raises interest rates when asset prices increase substantially and something that I've advocated in the past. Incorporating asset prices into the inflation index the Fed stabilizes is a very broad-brushed approach to the problem of fighting bubbles, so more targeted approaches are preferable). I realize that we have models saying it isn't possible to identify bubbles as they are inflating, but models aren't reality - they aren't always correct - and we won't really know until we try:
Monetary Policy and the Housing Bubble, Ben S. Bernanke, Chair, FRB: The financial crisis that began in August 2007 has been the most severe of the post-World War II era and, very possibly--once one takes into account the global scope of the crisis, its broad effects on a range of markets and institutions, and the number of systemically critical financial institutions that failed or came close to failure--the worst in modern history. Although forceful responses by policymakers around the world avoided an utter collapse of the global financial system in the fall of 2008, the crisis was nevertheless sufficiently intense to spark a deep global recession from which we are only now beginning to recover.You can view the full speech at the Federal Reserve site.
Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators' oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.
As with regulatory policy, we must discern the lessons of the crisis for monetary policy. However, the nature of those lessons is controversial. Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices. Obviously, in light of the economic damage inflicted by the collapses of two asset price bubbles over the past decade, a great deal more than historical accuracy rides on the resolution of this debate.
The goal of my remarks today is to shed some light on these questions. I will first review U.S. monetary policy in the aftermath of the 2001 recession and assess whether the policy was appropriate, given the state of the economy at that time and the information that was available to policymakers. I will then discuss some evidence on the sources of the U.S. housing bubble, including the role of monetary policy. Finally, I will draw some lessons for future monetary and regulatory policies.1
This post has been republished from Mark Thoma's blog, Economist's View.