Ben’s impotent interest rates
Originally posted Jan 14, 2010
WITH HIS SENATE CONFIRMATION FOR A SECOND TERM as a chairman of the US Federal Reserve Board delayed, Ben Bernanke took time to attend the annual meetings of the American Economic Association (AEA) in Atlanta on January 3. His pronouncements, however, must have confused many of those at the meetings as he tried to convince his audience that the low interest rates that had been engineered by the Fed during 2002-2004 had no part in fueling the housing bubble.
In response to the 2001 recession, the target federal funds rate had been lowered from 6.5% in 2000 to1.75% in December 2001, and to 1% in June 2003. After reaching a record low of 1%, the target rate remained at that level for a year. The Fed could not keep interest rates at such a low, as illustrated by the current near-zero interest rate policy, without massive liquidity injection. Most disappointing was his assertion that the US Fed had no responsibility in producing the ongoing financial crisis and that the housing crisis was purely the responsibility of supervisors and regulators.
The Fed chairman’s view in his own words was that: “Monetary policy from 2002 to 2006 appears to have been reasonably consistent with the Federal Reserve’s mandated goals of maximum sustainable employment and price stability. The availability of exotic mortgage products proved to be quite important and, as many have recognized, is likely a key explanation of the housing bubble. What policy implications should we draw? The best response to the housing bubble would have been regulatory, not monetary! Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs.”
Admission of responsibility for the financial crisis would be devastating for Bernanke’s tenure as the Fed’s chairman. With the rate of unemployment rate having risen already above 10% and today firmly entrenched at the 10% level, the government running the largest fiscal deficits in US history, and the banking system bailed out at the cost of trillions in government bailouts, raising any suspicion about Fed’s responsibility would erode confidence in Bernanke’s ability to remain the key US financial policymaker.
Hence, Bernanke threw back to the AEA participants the same arguments he presented to the US Congress: the housing bubble was caused by exotic mortgage products, deterioration of underwriting standards, and no documentation of loans; the appropriate policy response would be reforming and strengthening the regulatory and supervisory framework.
He added that the Fed could not recognize bubbles; these were recognized only in retrospect, which is after they burst, and therefore the Fed could not act to prevent bubbles. Simply, blame it on regulators. Instead, Bernanke claimed credit for bailing out banks and was portrayed by many as a savior.
Bernanke and his predecessor at the Fed, Alan Greenspan, have powerfully advocated the proposition that there is no relationship between monetary policy and asset bubbles. This view clearly assumes that interest rates are totally impotent. Greenspan and Bernanke opposed any tightening of monetary policy when housing speculation intensified, despite repeated calls from Edward M Gramlich, a former member of the Board of Governors of the Federal Reserve, and some prominent economists for a tightening of money policy with a view to stemming housing speculation.
Greenspan had previously opposed any tightening of monetary policy when the stock market bubble was gaining strength in 1987 and in late 1990s until the market crashed of its own force. He had repeatedly dismissed any responsibility in the current financial crisis. The Fed role was only to bail out banks and inject money when bubbles burst.
Such policy became known as Greenspan-put, encouraging banks to engage into speculative credit expansion, knowing full well that the Fed would bail them out. Adamant opposition by both Greenspan and Bernanke to any tightening of monetary policy for curbing credit expansion has undoubtedly turned out to be disastrous for the US economy, with the effects of the crisis expected to continue for many more years.
Bernanke’s pronouncements, designed to protect his legacy, make little sense. How can there be no relationship between interest rates and bank credit? How can he seek to refute the fundamental role for a central bank to use interest rates as an instrument of policy for limiting credit, inflation, and balance of payments deficits? Indeed, the central bank has been endowed with instruments for regulating the money supply and credit. Basically, these instruments are the rediscount and advances, reserve requirements, open market operations, and interest rate setting.
The central bank ought to deploy some of these instruments for managing liquidity and restraining credit expansion. Bernanke has forgotten two basic aspects of the banking system: interest rates and credit on one hand, and banking regulation and supervision on the other.
Interest rates and credit expansion, or contraction, are macroeconomic variables that can be regulated only by monetary policy. Bank regulation and supervision are a microeconomic responsibility. Supervisors and regulators analyze the balance sheet of one bank and ensure its compliance with safety standards. They have no control on money supply, credit, and interest rates; they cannot issue policy recommendation.
Credit aggregates for all banks fall under the jurisdiction of the monetary authorities. Banks could be perfectly compliant with supervision and regulatory standards, and yet, they may all expand at the same time through the credit multiplier, without violating safety standards, and run the systemic risk of credit default, contraction, and general bankruptcies.
Banks create and destroy money. The simultaneous expansion of bank credit turned out to be the major source of financial crises in the past. Irving Fisher attributed the Great Depression to over-indebtedness, that is, over credit expansion. Charles Kindleberger attributed it to cheap money, low interest rates, and virulent speculation.
It is disappointing to hear a denial of the role of interest rates in credit expansion by an expert of the Great Depression. According to Bernanke’s stand in Atlanta, one could conclude that interest rates, prices of shares, and credit had no role in the Great Depression. Had there been vigilant supervision and regulation, the Great Depression would have not taken place! All bank crises in the 19th century would be attributable to faulty regulation! Unfortunately, no banking system in the past, no matter how strictly safety regulation was applied, would have been able to survive the expansionary monetary policy that we have experienced in recent years.
It is not surprising to see Bernanke dismissing any relationship between interest rates and housing prices. He has also repeatedly dismissed any relationship between interest rates and commodity prices such as those for gold, oil and food, and exchange rates. He attributed oil price inflation to high consumption by China and India and restrained supply by the Organization of Petroleum Exporting Countries. He also rejected any relationship between interest rates and external deficits. Politicians believed his views. By dismissing a relationship between interest rates and commodity prices, Bernanke kept reducing interest rates when oil prices skyrocketed to US$147 a barrel and food prices rose to riot levels as huge quantities of food were diverted for ethanol production. Clearly, exorbitant oil and food prices crippled the world economy and precipitated world economic recession.
The thrust of Bernanke’s argument was that the housing bubble was caused by exotic mortgage loans and erosion of underwriting standards. He has mistaken the effect for the cause. These products were promoted and encouraged because of cheap money. Very low interest rates and abundant liquidity pushed by the central bank would necessarily increase competition among banks and hedge funds, reduce the income margin of lenders, and force banks to seek higher leverage to increase income, and to push their way into subprime markets through various financial innovations to loan up their abundant liquidity.
In conducting monetary policy, Bernanke was solely interested in what is called Taylor’s rule, which considers the short-term relationship between interest rate, unemployment, and inflation. It would appear that for Bernanke, any other variable not appearing in Taylor’s rule would be irrelevant and would not be influenced by interest rates. Using a narrow inflation measure, the core inflation that excluded energy, food, and asset prices, he forcibly argued that monetary policy was appropriate in view of unemployment objectives but he did not perceive that his policy had led to worst post-war financial crisis; although seemingly appropriate in 2004 in relation to unemployment, it unfortunately backfired and led to an unemployment rate exceeding 10% in the longer run in 2009.
Moreover, extremely low interest rates led to worsening of the external current account deficit to about 7% in 2006 and to more dollar liquidity placed by foreign investors in US banks, and lowering interest rates and in turn contributing to intensifying the housing bubble.
The controversy about monetary policy is an old one: whether the central bank should follow a fixed rule or a discretionary policy. Proponents of the fixed rule want the central bank to control monetary aggregates, ensure the stability of the financial system, and not interfere with the price mechanism and interest rate setting. Proponents of the discretionary rule, such as the Taylor rule, think that the central bank was also created to achieve full employment; it has to control prices, including interest rates; they worry little about the control of monetary aggregates; for that reason, credit expansion has never been a component of the Taylor’s model.
The distortionary effects of interest setting and the inevitable bank failures that credit expansion would entail are afforded little weight. The extreme view, as clearly contended by Bernanke in Atlanta, denied any effect of interest rates on financial stability or on variables such asset and commodity prices and exchange rates.
Bernanke’s cheap monetary policy continues to dominate US policymaking regardless of its effects. He has called for a strong regulation of the banking system so that a similar crisis does not occur again. Some politicians are now calling for regulation of the Fed as a way to prevent financial crisis.
The lesson that Bernanke learned from the crisis and wanted us to learn was that the regulation system was at fault and needed to be reformed. Recently, Tom Hoenig, president of the Kansas City Fed, warned against keeping rates too low for too long. He noted that “Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future.” Hoenig rejected Bernanke’s argument that the Fed decision to keep rates low after the dotcom crash did not contribute to the housing and credit bubble and stated that low interest rates contributed to excesses.
Bernanke is committed to the same policy that has led to the current economic and financial crisis. His near-zero interest rate will de-stabilize the financial system no matter how improved and strengthened the regulatory system becomes. Speculation has become rampant in asset and commodity markets. Although he denies a link between interest rates and commodities prices, oil and food prices have increased sharply in 2009 by about 70%. After crossing $83 a barrel, oil prices are heading toward higher levels and could constrain economic growth yet again.
Near-zero interest rates will erode capital income, savings, and investment. They provide free-lunches for speculators. A repeat of the seventies stagflation, or the recent Japanese lost decade, are not out of the question. The US economy could continue to suffer high unemployment, as in the 1970s, until policymakers find out that easy money may not the solution. By spreading confusion and absolving the Fed of any responsibility, Bernanke has only undermined confidence in the ability of the Fed to manage money, stave off speculation, and reduce the risks for financial instability.
Strengthening regulation is certainly a priority; however, perfect regulation would be incapable of preventing the damage of cheap money and negative real interest rates on the financial system, on the real economy, and on external deficits.
The concept of the Fed as an independent institution is totally blurred. Does an independent Fed mean unlimited influence for the views of its chairman, as in the case of Greenspan and Bernanke, or a Fed that can be protected both from excesses of its chairmen as well as from politicians?
Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.