Monday, January 04, 2010

Bernanke Fails To Exonerate The Fed

Here we go again, another Fed official tries to exonerate the Fed (or at least the Fed's monetary policy) from having caused the housing bubble. This time it is Bernanke himself in his latest speech. For Bernanke it is of course very important to try to exonerate the Fed since he was a leading advocate (together with Greenspan) of that policy, and since this could cause people to try to restrain, audit or even abolish the Fed. Blaming it on insufficient regulation of "exotic mortgages" by contrast would perhaps enable the Fed to increase its power.

I won't bother commenting on every error in the speech, and will instead focus on the most relevant errors with regard to the issue of the role of monetary policy.

1. Bernanke tries to measure monetary policy influence by the so-called Taylor rule and argues that with a different definition of the Taylor rule, monetary policy wasn't so loose.

But the Taylor rule is hardly a good gauge of monetary policy since first of all it has never been demonstrated or proven just why it is good and secondly because there isn't just one Taylor rule, there are dozens different Taylor rules being used. And with people adjusting the variables in the Taylor rule equation more or less arbitrarily to suit their own purposes (Bernanke's new version in the speech is in fact a perfect example of this), it becomes for all practical purposes useless in discussions between economists.

2. Bernanke tries to argue that based on the data they had then (which showed lower inflation then current revised statistics for the period) and given his own version of the Taylor rule, monetary policy was appropriate for stabilizing the economy. But since the economy turned out to be anything but stabilized, this only demonstrates that his policy approach is a failure.

3. Bernanke then tries to argue that monetary policy couldn't have been involved because other countries had house price booms despite supposedly more restrictive policies.

But that is misleading for several reasons. First of all, he uses the Taylor rule for evaluating policies, but that is problematic for above mentioned reasons. Secondly, the numbers he uses that are inaccurate or misleading for several reasons, including the fact that house price increases are not necessarily reflective of a bubble. It could also reflect previous undervaluation or structural factors like higher growth.

Because a monetary policy driven house price boom will eventually cause other prices to increase, forcing the central bank to raise interest rates, monetary policy driven house price booms are by their nature bubbles.

And while he tries to say that low rates couldn't have been involved because others didn't have it he fails to notice that in many other countries with housing bubbles (such as Spain), "exotic mortgages" and other things he blames for the U.S. bubble did not exist. Thus by his own method of evaluating explanations, his own explanation is refuted.

4. His other preferred explanation, capital inflows, is pathetic for other reasons, including the fact that capital inflows (otherwise known as current account deficits)are the effect of housing bubbles, not the cause. When you have a credit driven boom, demand for foreign building materials and other foreign products increase, causing the current account deficit.

While temporary capital inflows could under certain circumstances theoretically cause a housing bubble (namely if foreign investors invest in a certain country in an unsustainable way and then suddenly decides to stop investing in that country) the timing doesn't fit the U.S. bubble, which started in 2001 when the current account deficit fell, and stopped in 2006 even though the deficit continued to increase.