Federal Reserve and Financial Crisis
- Based on Lecture (2) by Ben Bernanke in George Washington University
The 1950s - post-war problems
Before proceeding, it is good to keep in mind the two key objectives of the central banks, that is, macroeconomic and financial stabilities. Now during the world war 2, the Fed was pressurized by the treasury to keep the longer-term interest rates low, so that the government debt (war finance) can be easily financed. However, keeping interest-rate low during the period of high growth leads to risks of rising inflation. So, by 1951 treasury agreed to let Fed independently decide the interest-rates and it is called as the Fed-Treasury Accord of 1951. This was a sign for the requirements of independent central banks since they could take long term approach and deliver better results while being away from short term gains as is generally aspired in politics (especially near the elections). Several studies have also clearly shown the benefits of independent central banks over non-independent ones.
The early 1960s - stable
Before world war 2 and the recent financial crisis, macroeconomic stability was the main concern for the central banks. During most of the 1950s and early 1960s, the Federal Reserve followed the policy of "lean against the wind" monetary policy that kept the inflation and growth quite stable.
The mid-1960s and 1970s - The Great Inflation
But, starting in the mid-1960s, the monetary policy was too easy. This led to a surge in inflation and inflation expectations and by 1970s the inflation peaked around 13%. The reasons behind the eased monetary policy were,
1. The optimism regarding the economy. In those time there was a permanent trade-off between inflation and unemployment, and therefore policymakers were comfortable with slightly higher inflations as well. It was Milton Friedman who argued that attempts to keep lower unemployment levels through the monetary policy will only lead to higher inflations and that monetary policy will only have transitory and not a permanent effect on unemployment.
2. Governmental pressures, which is debatable.
Exacerbating factors included,
1. Oil and food price shocks. For example, in October 1973, a war broke out in the Middle East. Due to the US's support of Israel, the middle east formed a cartel and raised the oil prices around three folds
2. Fiscal policies (such as spending in the Vietnam War) was too loose in the late 1960s and early 1970s
3. Nixon's wage-price control that artificially held down inflation for a time. Wage price controls were a series of laws that forbade firms to increase the prices, however, they were quite unsuccessful because it led to huge deficits and surpluses. Milton Friedman wrote that it was like treating the overheating furnace by breaking the thermostat. The fundamental problem, however, was too much demand which wouldn't be resolved through wage-price control
The 1980s and post - The Great moderation
In the 1970s, there was a reaction to high inflation. Chairman Volcker instituted a strong way to deal with double-digit inflation by increasing the interest rates. Volcker had said that to break the inflation the Fed needs to be credible and adopt a tight monetary policy. His policies worked, and when Volcker left his post in 1987, the inflation rate had declined to around 3 to 4 per cent. However, the effect of his policies to increase interest rates sharply also led to a sharp recession, for example, the unemployment rates in 1982 was around 11%.
During the Great Inflation of the 1970s, both the output and inflation were very volatile. The following terms of Volcker and Greenspan from mid-1980s to 2007 witnessed less volatile output and inflation. Thus, this period is also called the great moderation.
The following factors were responsible for the great moderation,
1. Improved monetary policy after 1979, which lead to low and stable inflation
2. Structural change (such as better inventory management) and simple good luck (such as fewer oil shocks) may also have contributed.
The period, however, also witnessed some financial stresses, such as the 1987 stock market crash and the 2000s dot-com bust, but it did not create large economic distress. Due to relative tranquillity in this period, monetary policy received greater emphasis than financial stability policies.
The 2000s
From the late 1990s until early 2006, the house prices soared to 130 per cent. Meanwhile, mortgage lending standards deteriorated. Rising house prices and deteriorating mortgage complemented each other. It was believed that the house prices would keep soaring and were the best investments. Thus, the lax underwriting and the availability of easy mortgages kept soaring up the prices.
Before the 2000s, homebuyers were required to make a downpayment and submit documentation before financing. But as the house prices soared, the lenders began offering loans even to less qualified borrowers (non-prime mortgages), with least documentation and down payment. But as the prices kept on rising, the mortgage payments (as a fraction of personal disposable income) also rose, till the time it became unsustainable, and this then began to damp the housing demand. This decline in demand then led to a decline in the house prices beginning in early 2006.
As the house prices fell, borrowers, especially who had made little or no downpayment, went underwater (that is, the amount of money they owed was more than the value of their house). This led to a surge in foreclosures (bank taking over the property) and delinquencies (selling the acquired properties to someone else). Banks and other holders of mortgage-related securities suffered sizeable losses, which proved to be an important trigger for the crisis. The decline in house prices and the mortgage losses triggered the crisis, but the effects of those triggers were amplified by vulnerabilities in the economy and the financial system.
The late 1990s and early 2000s witnessed a similar amount of losses in the wall street as the 2008 crisis. But the point fo difference between them is the effect on the financial system and the economy. The dot-com bust created a mild recession as opposed to the housing crisis. It is therefore when the house prices had begun to decline, it was believed to behave more like the 2000 crisis, which, as we all know now, turned out to be wrong. So, as we discussed, it was the vulnerabilities which amplified the housing boom and bust into a big crisis.
1. Private sector vulnerability
(a) Borrowers and lenders took too much leverage and one reason why they would have done that is the period of great moderation. There was a stable period for around 20 years which would have strengthened their confidence to take on more debt.
(b) Throughout this time, the financial instruments became more and more complex, and banks and other financial institutions failed to adequately monitor and manage the risks they were taking
(c) Firms relied excessively on short term funding, such as commercial paper
(d) Increased use of complex financial instruments. For example, AIG insured a large amount of CDO's. In other words, AIG promised to pay the holders of insurance the decided amount in case the CDOs go bust and thus till the time the economy was doing good they only kept on collecting the premiums, but once these things went bad they were exposed to huge losses
2. Public sector vulnerability
(a) Gaps in the financial regulatory structure left firms like insurance firm AIG, investment banks Bear Stearns, Meryl Lynch etc, without strong supervision
(b) There were failures of regulation and supervision, including consumer protection. The Fed had some authorities to provide some protection to the mortgage borrowers, which it had been used effectively would have restricted some of the bad lendings that occurred during the latter part of the housing bubble
(c) Insufficient attention was paid to the stability of the financial system as a whole. This was because of the way the entire system was structured. Generally, individual regulatory institutions were responsible for a specific set of firms, for example, the office of thrift supervision was only responsible for thrifts in similar institutions. But unfortunately, the problems that arose during the crisis were broader, they transcended a single firm or a group of firms. And so nobody was actually in-charge to look if the entire system was under crisis
(d) Fannie Mae and Freddie Mac are private corporations established by the congress referred to as government-sponsored enterprises. They don't give mortgages but act more like a middle-men between those the ultimate borrowers and lenders of the mortgages. So, the bank can sell all their mortgages to Fannie and Freddie, who will then pack the individual mortgages into mortgage-backed securities (MBS, a combination of hundreds or thousands of underlying mortgages) and then sell these securities to investors. In particular, when Fannie and Freddie sell their securities, they provide guarantees against credit loss. Fannie and Freddie were permitted to operate with inadequate capital to back their guarantees. Not only did they sell the MBS to the investors, but also purchased the large amount on their own, and made profits by holding those MBS. But by this, they also exposed themselves to higher risk
3. The role of monetary policy
(a) Many people have argued that the Fed kept the interest rates low during the early 2000s which contributed to the housing bubble and triggered the crisis.
Some of the evidence from the studies done within the Fed, however, disapproves these claims. The studies show that the UK had a house price boom during the 2000s despite tighter monetary policy than the US. Also, Germany and Spain sharing the common central banks witnessed a relatively stable and enormous surge in the house prices respectively during the period. Another study compares the change in interest rates (including mortgage rates) to movement in house prices historically and concludes that the changes in the house prices were way too large to be explained by the relatively less change in the interest rate associated with the monetary policy during the 2000s. Robert Shiller suggested that the bubble actually began in 1998, much before the monetary easing. In fact, the house prices began to rise sharply after monetary policy began to tighten in 2004. What these suggest, however, is the optimism might be a factor, which had led to the tech boom and might have resulted in the house price surge. Additionally, the 1990s witnessed the crisis in Asian countries and some emerging market economies, after which these countries started accumulating safe dollar assets (including mortgage-based assets) to serve as reserves. This increased the demand for assets, including mortgages. Probably the strongest cross country correlation for the increase in house prices is the capital inflow, that is, the amount of money coming in to buy mortgages or other "safer" assets.
Comments
Post a Comment