Thursday, April 3, 2008

The Role of the Fed in Creating the Current Financial Crisis

I have made the case for some time (here, here, and here most recently) that an overly accommodative Federal Reserve in the early-to-mid 2000s set the stage for the biggest housing boom-bust cycle in U.S. history. Some notable observers such as John Taylor and The Economist have also taken a similar view, but up until now they have been the exception rather than the rule. Others are beginning to adopt this view as well:
Jeffrey Sachs
To a large extent, the US crisis was actually made by the Fed...Today’s financial crisis has its immediate roots in 2001, amid the end of the Internet boom and the shock of the September 11 terrorist attacks. It was at that point that the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate – the Federal Funds rate – from 3.5% in August 2001 to a mere 1% by mid-2003. The Fed held this rate too low for too long.

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Ricardo Hausmann
The discussion about avoiding a repetition of the current financial crisis has centered on the potential role of financial regulation...it is hard to see how the kind of financial regulation that would be called for would have avoided the current crisis. I believe that financial regulation is the wrong place to focus the policy discussion about the causes of the current crisis. It is macro policy, not financial policy that needs to be at center stage.

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Andy Laperriere
... The housing boom began in earnest when the Fed slashed interest rates in response to the 2001 recession, and kept rates too low for too long. The lower interest rates cut monthly mortgage payments and fueled the first wave of home-price appreciation, which began to take on a life of its own. Artificially low interest rates reduced returns on safer investments like government and corporate bonds, so investors moved funds into riskier assets (like subprime loans) to increase returns. Low interest rates also made it profitable to borrow heavily in order to invest in mortgage-backed securities and other financial assets, and leverage grew at a breathtaking clip.

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(Not excerpted above, but worth noting is Brad DeLong. DeLong sees the merit in this view, but is having a hard time coming to terms with it and wants to see it formalized. Maybe this research will meet his needs.)
A key insight from these observers is that loose monetary policy not only worked through the traditional transmission channels in creating this boom-bust cycle, but also through a 'financial innovation' channel. The Fed's holding down of short-term interest rates so low for so long lowered returns on many investments. This created a 'search for yield' and made investors more open to riskier, more exotic financial products. This increased demand for riskier projects was met by an increase in supply from the financial wizards on Wall Street and, in turn, stimulated further credit creation. An interesting idea.

2 comments:

  1. I've heard some say this is similar to Austrian business cycle. Can you elaborate on that? -scott cunningham

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  2. The idea that lower rates led investors to riskier products and Wall Street accomidated is interesting. I wonder how many of these investors were demanding lower rates at the time? Why does it seem like the Fed is always the scapegoat? Where is the accountability? Isn't caveat emtpor still a princple people follow?

    I have been working on an analagy- "Investors demanded guns, the Fed opened the armory and the Street supplied the bullets. Things were great till people started shooting themselves in the feet. The real losers might be the middle class, simply caught in the crossfire"

    I am still a student and understand that I have a lot to learn but I do believe the following.
    The Fed makes decsions based the best resources. The Fed's objectives are sustainable economic growth, full employment and price stability.
    Investors seek to maximize return on a given level of risk.
    Wall Street wants to profit.
    When they borrowed too much, made bad investments, etc. individuals and institutions were at least as much(and possibly more than)at fault as the Fed.

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