Speech by Ben S. Bernanke, Commentary

Monetary Policy and the Housing Bubble
At the Annual Meeting of the American Economic Association

January 2, 2010

This is a speech in front of an association of economists, and, consequently, Bernanke can talk freely in his “native language”. He can use the reasoning and terms with which he is most comfortable, keeping in mind that it is in public and the speech will be reported. This speech is his personal, professional statement of what he considers to be the consequences of his actions as a government official.

First, Bernanke’s comments make clear that in his opinion, the range of options that he faced or would not consider appropriate do not extend to letting interest rates rise to the market level. Those who argue the rates were too low, he says, meant that he should have done something different, not leave his hands off. As he was reported to have said in the book In Fed We Trust (p. 21), he was unpersuaded by arguments that the market can be effective by itself. In addition, he says that he was afraid of an unwelcomed decline in inflation. He was afraid of deflation, referring to Japan as an example of what can happen if prices fall.

“…the FOMC’s policy response also reflected concerns about a possible unwelcome decline in inflation. Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation.”

That he has no evidence that deflation in the U.S. was happening, or that it would have been bad is not considered. What he is actually saying is that falling prices is a bad thing for any economy. Falling prices are to be avoided at all costs. Falling prices, plus the potential for large scale problems in the financial sector world wide meant probable depression.

Bernanke has established himself as an expert on the Great Depression. His take on the depression is that it could have been avoided if the Fed had flooded the market with money in 1931 and 1932. This is his perspective. If something goes wrong in the economy, lower the interest rates.

Bernanke’s speech begins with discussion of the level of the overnight federal funds interest rate between 2002 and 2006. The question is whether it was appropriate in the face of the critics. He thus says that he will begin with a discussion of “simple rules” that have been offered to determine the proper rate, and talks about one, only one. And with the conclusion of this discussion, he simply dismisses the issue of the interest rate levels by saying that it appears that the Fed followed the correct policy.

The “simple rule” is a formula suggested by an academic that includes the actual rate of inflation, the desired rate of inflation, and the deviation from the optimum level of production. Bernanke quibbles about some of these terms, and ends by declaring that, even if the final result, after he has tinkered with the terms, is close to what the short-term interest rate goals that the Fed actually achieved, it is still too restrictive to be used. Sound strange? It is. I don’t recommend reading that section (or any of them, really; what’s that fun saying that some media types are using, “I read it so that you don’t have to”). (I am sorry. This section of the speech, about 25% of the text, is just not easily translated.)

He also uses only the level of prices, consumer prices as the subject matter of inflation. If prices rise there is inflation. If prices fall there is deflation. He is not willing to suggest that there is any other set of issues. Money supply is not an issue. It is not mentioned during the speech. Other causes for price rises, such as restrictions on oil production and thus higher oil prices, which tend to make other prices are not considered, at least in this speech. (He would probably like this suggestion, since it would be yet another explanation of “inflation” in which the central bank played no part.)

As you would expect, the concrete-bound detail and triviality of his remarks make this extremely tedious to read, as, I am sure, to hear by his listeners. Of course, they were mostly mainstream economists and government people and are used to hearing this kind of speech.

He then asks “can monetary policy have made an impact on housing prices?”

“With respect to the magnitude of house-price increases: Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy. This conclusion has been reached using both econometric models and purely statistical analyses that make no use of economic theory.”

Bernanke’s answer is founded in statistical analysis. He doesn’t use cause and effect, but looks for correlations. These techniques also depends upon focusing on the interest rate at the time and price inflation. What they ignore entirely is how low interest rates are achieved. He pretends that the fed declares low interest rates and they come about. But what happens is that to keep interest rates low, even the short-term rates, the Fed must supply funds. It must make up money. It must keep making money (this is electronic money) as long as it wants to keep the interest rates below what the market would set. Every time there is a move upward, the Fed makes up more money. Where does this money go? In the period in question, much of it went into mortgages. But Bernanke does not think that looking at this money makes any sense. He ignores it as if it doesn’t exist. But it does, or did until the liquidation of mortgage-backed securities became necessary because of so many defaults, which was the liquidation of the mortgages.

His entire speech demonstrates that the epistemological methods used in today’s mainstream economics is designed to avoid looking at reality and to obfuscate cause and effect.

He slips in the suggestion that the availability of ARMs and other special mortgage types is a “key” explanation of the rise in house prices.

“Clearly, for lenders and borrowers focused on minimizing the initial payment, the choice of mortgage type was far more important than the level of short- term interest rates. The availability of these alternative mortgage products proved to be quite important and, as many have recognized, is likely a key explanation of the housing bubble.”

At this point the level of evasion of responsibility becomes obvious, since the Fed, as well as every other imaginable government agency had pushed home ownership and the lowering of credit standards for years. (see Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas Woods, p. 15ff)

“As you can see, the use of these nonstandard features increased rapidly from early in the decade through 2005 or 2006. Because such features are presumably not appropriate for many borrowers, Slide 8 is evidence of a protracted deterioration in mortgage underwriting standards, which was further exacerbated by practices such as the use of no-documentation loans. The picture that emerges is consistent with many accounts of the period: At some point, both lenders and borrowers became convinced that house prices would only go up. Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained and house prices collapsed.”

To further support his position that the Fed is blameless, he considers the rise of house prices internationally. Bernanke uses the same statistical method of comparing monetary policy, as represented by a statistical analysis of the central bank short-term rates compared to the rise of house prices in separate countries. He finds no correlation. So the central bank of the U.S., the Fed, did not cause the rise in house prices. QED! The guy is a wizard! And, it is entirely nonsense. He has no concept of the role of cause and effect in economics. That is where we are, and why he and his brothers are completely mystified as to why people want to shut them down.

So what explains it, in Bernanke’s opinion: savings glut, especially in developing countries. It seems that the people who feed off of money loaned or “invested” in developing countries turn around and put the money in the U.S. Since this money is usually dollars and it isn’t actually U.S. savings, but made-up money, it is U.S. inflation anyway. But that is far too long of a chain for Bernanke to accept or even consider. Yet, here we are, foreign savings sent to the U.S. has driven up American house prices.

Step back and consider our house prices dependency on foreign money for a second. With Bernanke is keeping American interest rates low, why would anyone send us money. Well maybe, if your own country’s currency is even less stable, the U.S. is a fine place to put your money, or maybe you have so many dollars you need someplace to put them.

Somehow Bernanke can keep track of the money coming into the U.S., he says (actually, he is suggesting it, cause and effect is something that he is avoiding), but he can’t or won’t consider what is being done with the money the Fed is creating to keep the interest rates low in the first place. There is a parallel, Bernanke admitted in front of Congress that he doesn’t know what happened to the money that he loaned/gave to foreign central banks as part of the stabilization after September, 2008. He doesn’t watch it, except for that money that came from developing countries that drove up house prices in the U.S.

“In previous remarks I have pointed out that capital inflows from emerging markets to industrial countries can help to explain asset price appreciation and low long-term real interest rates in the countries receiving the funds -- the so-called global savings glut hypothesis (Bernanke, 2005, 2007).”

In his argument that central bank short-term interest rate policies are not responsible for the increase in house prices, Bernanke’s approach shows that there is a very significant methodological issue here. Bernanke felt that all he needed to do was create charts comparing the central bank interest rates with the house prices. He didn’t feel it was important to consider the actual money market in each country, or credit standards, if credit is used, type of mortgages, income levels of house purchasers, laws, or any feature that might or might not make each county a relevant candidate for comparison with the U.S. situation. No, all that is needed in Bernanke’s world is a look for the correlation. I have watched reactions to Bernanke’s speech and I have seen no reaction at all to his analytical methods. I suspect that the standard journalist is intimidated by what passes as Bernanke’s science. I saw one comment on a critic’s article saying that he thought Bernanke was smarter than the author of the article and so would continue to believe Bernanke. That is part of the problem, a lack of understanding of simple methodology.

And, therefore, after his analysis of the appropriateness of his low short-term interest rate policy and the possibility of Fed responsibility for the rise in house prices, both of which Bernanke resolved in his own favor, the cash payout, the conclusion, the recommendation is, wait for it, what do you think, you get three answers and the first two don’t count, what do you think it could be….(consider this all said in a high voice with a drum roll)…… it is, to da, MORE REGULATON!!!! SURPRISE!!!

Sorry, I couldn’t resist.

“What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that 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. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk- management practices without necessarily having had to make a judgment about the sustainability of house price increases.

“The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.

“The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by- institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.”

The nicest thing that can be said is the he must be well insulated. The push to expand home ownership and lower credit standards by the government was a very big effort. To ignore that takes a heap of mental effort. The other problems I have touched upon.

But, the basic modus operandi of a government regulator is well established by excellent writers, Ayn Rand, Ludwig von Mises, and many more. When something goes wrong in the economy you are regulating always blame it on free enterprise and never yourself. And demand, loudly and often, more controls and power and less freedom.

(Bernanke's speech    http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm)