Academic vs. Wall Street Economists

The WSJ recently asked a number of economists whether they thought the Fed's low interest rates in the early-to-mid 2000s were an important contributor to the credit and housing boom. What the WSJ found was interesting: most business and Wall Street economists (78%) answered yes while just less than half of the academic economists (48%) said yes. One way to interpret this difference is that economists who are closer to the actual financial system may sometimes see better how the low rates actually influence it. Take, for example, the difference between the academic economist Richardo Caballero and the Wall Street economist Barry Ritholtz on what drove the demand for the riskier assets during the boom. Richardo Cabaello's story is a structural one dealing with a shortage of safe assets relative to the global demand for them:

By 2001, as the demand for safe assets began to rise above what the U.S. corporate world and safe mortgage‐ borrowers naturally could provide, financial institutions began to search for mechanisms to generate triple‐A assets from previously untapped and riskier sources. Subprime borrowers were next in line, but in order to produce safe assets from their loans, “banks” had to create complex instruments and conduits that relied on the law of large numbers and tranching of their liabilities. Similar instruments were created from securitization of all sorts of payment streams, ranging from auto to student loans... Along the way, and reflecting the value associated with creating financial instruments from them, the price of real estate and other assets in short supply rose sharply. A positive feedback loop was created, as the rapid appreciation of the underlying assets seemed to justify a large triple‐A tranche for derivative CDOs and related products.

What is interesting about Cabellero's story is that there is not one mention of how incentives created by the low interest rates may have contributed to this process. Barry Ritholtz, on the other hand, sees a big role for the low interest rates in creating demand for riskier assets:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

Now Ritzholtz acknowledges regulatory failures were important as well, but the fact that he sees a role for distorted incentives created by the low federal funds rate in creating demand for riskier assets while Cabellero does not may speak to the fact that Ritzholtz is on the ground at Wall Street. Now their two views may actually complement each other. However, one is left wondering whether their differences and that between academic and Wall Street economists more generally on the importance of the Fed's low interest rates can arise based on proximity to the action in financial markets.

More on Bernanke's AEA Speech

Here are more responses to Bernanke's AEA speech where he defended the Fed's low interest rate policies in the early-to-mid 2000s:

(1) John Taylor in the WSJ
(2) John Taylor on Economics One
(3) David Papell at Econbrowser
(4) John Hilsenrath at WSJ [update: video]
(4) Mark Thoma & Vernon Smith on Economist's View
(5) Josh Hendrickson at Everyday Economist

These responses are consistent with my own thoughts on Bernanke's speech. Finally, it is worth noting that Brad DeLong acknowledges that the federal funds rate may have been too low at the time. However, he has a hard time seeing how the low interest rates could have been an important contributor to the housing boom. Let me first say I am glad that Brad DeLong is at least open to the idea that interest rates may have been too low. Second, I would encourage him to look beyond the normal monetary transmission channels in assessing how important the low federal funds rates were to the housing boom. There is obviously more to the story than just low interest rates, but one should not underestimate the effect of them in light of the risk taking channel of monetary policy.

The Optimal Eurozone and the Optimal Dollar Zone

There has been a lot of discussion recently over the potential break-up of the Eurozone. Commentators such as Martin Wolf, Paul Krugman, and even the ECB have highlighted problems in some of the periphery nations of the Eurozone that could cause them to eventually abandon the Euro. As Krugman notes, this discussion is ultimately based on theory of the optimal currency area:

The basic idea is that there’s a tradeoff. Having your own currency makes it easier to make necessary adjustments in prices and wages, an argument that goes back to none other than Milton Friedman. As opposed to this, having multiple currencies raises the costs of doing business across national borders.

What determines which side of this tradeoff you should take? Clearly, countries that do a lot of trade with each other have more incentive to adopt a common currency: the euro makes more sense than a currency union between, say, Malaysia and Ecuador. Beyond that, the literature suggests several other things that might matter. High labor mobility makes it easier to adjust to asymmetric shocks; so does fiscal integration.

Some of Krugman's readers have been asking him what are the implications for the United States from this theory. I happen to have a paper [ungated version]that looks at this very question. In the paper I frame the issue this way:

Is the United States best served by a single central bank conducting countercyclical monetary policy? According to the optimal currency area (OCA) criteria, the answer is yes if the various regions of the United States (1) share similar business cycles or (2) have in place flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. In the former case, similar business cycles among the regions mean that a national monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. In the latter case, dissimilar business cycles among the regions make a national monetary policy destabilizing—it will be either too stimulative or too tight—for some regions unless they have in place the above listed economic shock absorbers.

[...]

Consider, for example, a region in a currency union whose economy is not well-diversified and is slowing down because of a series of negative shocks to its primary industries. If the monetary authorities in this currency union decide to tighten because the other regional economies are expanding too fast then the region slowing down needs price flexibility, labor mobility, and federal fiscal transfers in order to offset the effects of the contractionary monetary policy. If these economic shock absorbers are absent, then this region would find this tightening of monetary policy to be further destabilizing to its economy. In general, the greater the dissimilarity of a region’s business cycle with the rest of the currency union the more important these economic shock absorbers become for the region to be a successful part of an OCA.

Graphically, this understanding can be depicted as follows:

Along these lines, I explore in the paper how different state economies respond to a typical monetary policy shock for the period 1983-2008 and compare it to the response of the U.S. economy to that same shock. Comparing the state economies to the U.S. economy is useful since the U.S. economy is the target of monetary policy. To illustrate this exercise, I have graphed below how Texas and Michigan typically responded to such shocks over this time. The solid lines below represent the change to the real economy (measured by coincident indicator) after the monetary policy shock for each region while the dashed lines provide standard error bands which help provide a sense of precision. (Click on figures to enlarge.)


Note that relative to the U.S. economy, the Michigan economy gets hammered by the typical monetary policy shock while Texas does about the same. These disparate responses to U.S. monetary policy shocks suggests that some parts of the U.S. economy may not part of the dollar OCA. Based on this and other empirical evidence in the paper I conclude that the Rustbelt may have benefited from having its own currency. The U.S. economy, then, may not be after all the benchmark OCA case against which the European would want to measure themselves.

John Cassidy on the Greenspan Put

John Cassidy shows no mercy in critiquing Bernanke's defense of the Fed's low-interest rate policies in the early-to-mid 2000s and more generally the Fed's asymmetric response to swings in asset prices:

Behind his white beard, Federal Reserve chairman Ben Bernanke has a wry sense of humour. On reading his recent speech to the American Economic Association, in which he defended the Fed’s actions during the housing bubble, I initially suspected it was a practical joke. Rather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision.

Searching in vain for a punch line, I was reminded of Talleyrand’s quip about the restored Bourbon monarchs: “They have learned nothing and forgotten nothing.” Mr Bernanke is far smarter than Louis XVIII and Charles X, two notorious boneheads, and has done a good job of firefighting. But his unwillingness to admit the Fed’s role in inflating the housing and broader credit bubble raises serious questions about his judgment.

The individual elements of his presentation were questionable enough... but most disturbing was its failure to address the larger picture: from the mid-1990s, the Fed adopted a stance that encouraged irresponsible risk-taking. In periods of growth, it raised interest rates slowly, if at all, stubbornly refusing to acknowledge the course of asset prices. But when a recession or financial blow-up beckoned, it slashed rates and acted as a lender of last resort.

On Wall Street, this asymmetric approach came to be known as “the Greenspan put”. It gave financial institutions the confidence to raise their speculative bets, using borrowed cash to do it. None of the Fed’s actions since then have addressed this central issue of moral hazard. Indeed, the problem may have become worse. For all the damage that the financial industry has inflicted on itself, when disaster arrived the Greenspan/Bernanke put did pay off. By slashing the funds rate and providing emergency credit facilities to stricken financial firms, the Fed further entrenched the perception that its ultimate role is to provide a safety net for Wall Street.

Unlike his predecessor, Mr Bernanke recognises the problem of excessive speculation and the massive externalities its sudden reversal can impose. In that sense, intellectual progress has been made. But he and his deputy, Donald Kohn, still refuse to acknowledge the Fed’s role in motivating reckless behaviour...

This is not entirely true, at least for Donald Kohn. In a November 2007 speech Kohn hints at this possibility via a comment on the Fed's role in creating the Great Moderation:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

The victim of my own success tone is slightly annoying here, but at least Kohn alludes to some of the concerns associated with the Greenspan put. Still, Cassidy's bigger point holds: the Fed has yet to fully account for its role in causing investors to underestimate aggregate risk and, as a result, make decisions that contributed to the financial crisis on 2008-2009.

John Taylor Responds to Bernanke's Speech

It is good to see John Taylor pushing back against Bernanke's defense of the Fed's low interest rate policies in the early-to-mid 2000s:

Jan. 5 (Bloomberg) -- John Taylor, creator of the so-called Taylor Rule for guiding monetary policy, disputed Federal Reserve Chairman Ben S. Bernanke’s argument that low interest rates didn’t cause the U.S. housing bubble.

“The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust,” Taylor, a Stanford University economist, said in an interview today in Atlanta.

Taylor, a former Treasury undersecretary, was responding to a speech by Bernanke two days ago, when he said the Fed’s monetary policy after the 2001 recession “appears to have been reasonably appropriate” and that better regulation would have been more effective than higher rates in curbing the boom.

[...]

“It had an effect on the housing boom and increased a lot of risk taking,” said Taylor, 63, who was attending the American Economic Association’s annual meeting.

Taylor echoed criticism of scholars including Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who say the Fed helped inflate U.S. housing prices by keeping rates too low for too long. The collapse in housing prices led to the worst recession since the Great Depression and the loss of more than 7 million U.S. jobs.

[...]

“Low rates certainly contributed to the crisis,” Baker said in an interview on Jan. 3. “I don’t know how he can deny culpability. You brought the economy to the brink of a Great Depression.”

Nice to hear from Dean Baker too. Read the rest of the article here.

A Note to Ryan Avent, Paul Krugman, and Arnold Kling

Do not underestimate the impact of the Fed's low interest rate policies in the early-to-mid 2000s. While there are many stories told as to how the low federal funds rate at this time contributed to the housing boom, one that is often overlooked but probably the most important is the "risk-taking" channel story of monetary policy. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

Tobias Adrian and Hyun Song Shin also explore this channel in their paper:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

Both papers above empirically show the low federal funds rates were very important to the excessive leverage and big bets made by financial institutions during this time. Barry Ritholtz provides a nice summary of this channel in a recent post:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...

An honest assessment of the crisis’ causation (and timeline) would look something like the following:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

[...]

Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

Now Ritholtz acknowledges there were many factors at work during this boom. However, he makes the point, and I agree, that we have failed to learn a key lessons from this crisis if we move forward with the view that the low interest rates were of no consequence during the housing boom.

Bernanke Goes for the KO and Misses

Ben Bernanke came out swinging today throwing some hard punches at those critics who say the Fed's monetary policy was too accommodative in the early-to-mid 2000s. He does so by throwing the following four-punch combination of arguments: (1) economic conditions justified the low-interest rate policy at the time; (2) a forward looking Taylor Rule actually shows the stance of monetary policy was appropriate then; (3) there is little empirical evidence linking monetary policy and the housing boom; and (4) cross country evidence indicates the global saving glut, not monetary policy was more important to the housing boom. Though Bernanke rejects the view that interest rates were too low for too long in this speech, he does acknowledge the Fed could have been more vigilant in regulatory oversight of lending standards. By far this is one of the better defenses of the Fed's low-interest rate policy of the early-to-mid 2000s that I have seen. Arnold Kling seems convinced by this rebuttal while Mark Thoma appears more agnostic about it. While Bernanke's case seems reasonable for the 2001-2002 period, I find his arguments far from convincing on all four points for the period 2003-2005 and here is why:

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate--measured by final sales of domestic product--and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):


Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed:


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an "improved" Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule's merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down--a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap--i.e. productivity growth greatly exceeds the real interest rate--emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters):



This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the "risk-taking" channel the Fed's low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed's low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:


They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the "search for yield" created by the Fed's low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.