Bernanke: Lack of Regulation to Blame for Housing Bubble

A lack of governance was responsible for the US housing bubble and not monetary policy, Federal Reserve Chairman Ben Bernanke declared as he addressed the American Economic Association yesterday in Atlanta. According to Bernanke, lowering lending rates to boost the economy after the disintegration of the “dot-com” bubble at the turn of the century may have helped give rise to the housing bubble, but it was a lack of regulatory oversight that enabled the price valuation run-up and ultimate collapse of the bubble, triggering what would become the worst global recession since the Great Depression of the 30s.

[mserve id=”Central_Bank_FED_Bernanke.jpg” align=”left” width=”400″ caption=”Fed Chairman Ben Bernanke” alt=”US Federal Reserve Chairman Ben Bermanke Fed” title=”Fed Chairman Ben Bernanke”]

Just over a year ago, Bernanke’s predecessor, Alan Greenspan, told the Government Oversight Committee that a “once-in-a-lifetime credit tsunami” was primarily responsible for causing the recession. Like Bernanke, Greenspan minimized the role the Federal Reserve played, blaming instead a series of events that no one could have predicted as being mostly responsible. Bernanke did stray from the Greenspan playbook however, by pointing directly at regulatory “weaknesses” as the principle culprit, and this is something we would never have heard from Greenspan who always favored “market forces” over regulations as the ultimate form of market management.

“The crisis revealed not only weaknesses in regulators’ oversight of financial institutions”, said Bernanke, “but also, more fundamentally, important gaps in the architecture of financial regulation around the world.”

Bernanke told the audience that even as the Federal Reserve worked to stabilize economic uncertainty and move the economy forward, the Fed was making every effort to “learn the lessons of the crisis so that we can prevent it from happening again”.

“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.”

While tracing the genesis of the housing bubble to the dot-com-triggered recession, Bernanke acknowledged that the Fed did indeed lower lending rates to combat the rapidly shrinking economy, but as the economy responded, rates were subsequently increased back to more typical levels. Despite the return to higher interest rates, house prices continued to rise at an accelerated pace.

The failure to recognize the potential for a housing bubble at this time is certainly a major failing on the part of the authorities, but for whatever reason, the warning signs were – initially at least – ignored. It seems people were too busy celebrating the end of the recession to worry about the next risky asset bubble. The economy was growing at a healthy rate; inflation was under control; employment was increasing; and Americans were enjoying the most productive period in a generation.

But all was not well if one cared to dig a little under the surface. Overall debt in America – both personal debt and government debt – was on the rise and homeowners were cashing in on their rapidly increasing property values to underwrite trillions in new consumer loans. The financial industry got in on the action by making it easier for people to qualify for mortgages through its rapidly increasing reliance on sub-prime mortgages, safe in the knowledge that the mortgaged property would continue to gain in value. Worse still, individual mortgages were being wrapped up in huge CDOs making it impossible to accurately evaluate the actual risk of individual tranches being sold in the retail sector.

All that of course is old news, and Bernanke wants us to move beyond this to learn from the mistakes of the past. And the first thing Ben wants you to know, is that it was not the Fed’s fault.

Sure, the Fed’s policy of low interest rates to stimulate the economy may have “inadvertently contributed to the housing bubble”, but it was not the only factor. In fairness to the Federal Reserve, the Federal Funds Rate which was set at 1.25 percent in November of 2002, climbed steadily as the economy recovered and stood at 5.25 percent by June 2006. As we all know, the housing bubble collapsed in late 2007, throwing first the US, and then the entire global economy into a tailspin, eventually forcing the Fed to lower rates to a historical low range of zero to 0.25 percent. Despite the record low lending rates currently in effect, no one’s talking about a housing bubble now so maybe there is more to be considered than interest rates alone.

To further illustrate his claim, Bernanke points to the fact that the Federal Reserve continued to raise interest rates even as the housing bubble expanded, as evidence that while monetary policy may have initially been “accommodative”, as the housing bubble became established, further direct linkages to the Fed’s monetary policy, are “weak”.

“Because monetary policy works with a lag, policymakers’ response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period – though certainly accommodative – does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives.”

Bernanke places the blame directly on the financial sector and the practices of private lenders, coupled with a lack of regulatory oversight. Bernanke claims that the Federal Reserve under then-Chairman Alan Greenspan did attempt to reverse the growing trend towards “non-traditional” (read, high-risk, subprime) mortgages. This effort continued after Bernanke became the Chairman and in March 2007, the Federal Reserve issued new guidelines for subprime lending. Unfortunately, this came far, far too late as the housing bubble collapsed for good just a few months later in the fall of 2007.

Ultimately, Bernanke advocates for the strengthening of the regulatory system to reduce the likelihood of another asset bubble triggering a wide-spread economic panic in the future. It is only if these new regulations fail to prevent an increase in risk however, should attention turn to directed economic policy, and only as a “supplementary tool for addressing those risks”.

Text of Bernanke’s Speech

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