Tag: Federal Reserve

Popping Bubbles

David Leonhardt’s column today in the New York Times, in reaction to Ben Bernanke’s recent speech at the American Economic Association meetings, asks an important question:

If the Federal Reserve failed to detect the housing bubble when it occurred, why should we entrust it with that role in the future?

But he doesn’t follow the logic of his question far enough and instead embraces a financial equivalent of the National Transportation Safety Board, as if technical solutions exist and could be implemented if politics got out of the way.

In our recent Policy Analysis, Jagadeesh Gokhale and I examine a more complete list of technical and political problems that stand in the way of asset bubble management. Can bubbles be detected using scientific techniques (econometric models) with little controversy? We argue no.

Would stopping bubbles involve the simple implementation of a technical solution such as raising interest rates, or would they instead involve trade-offs with other policy goals? We argue the latter.

Even if bubbles could be detected easily with no controversy and policy solutions involved no tradeoffs, could the Fed maintain political support by stopping booms if the benefits of such a policy (preventing busts after financial bubbles burst) were never observed? We argue no.

And finally, even if all the previous problems were solved, how would raising interest rates reduce the supply of capital to housing markets given that a rate increase would increase the supply of capital to the United States and interest rates for both long-term and short-term housing loans have become decoupled from federal funds rates?

Our reasoning, like Bernanke’s, suggests that the events of 2008 were not the result of “bad” monetary policy. However, we believe that granting additional regulatory authority to the Fed will not prevent similar episodes because of the technical and political difficulties we describe in our paper.

Did the Fed Buying MBS Make a Difference?

Recent years have witnessed a multitude of new Federal Reserve programs aimed at bringing stability to our financial markets.  One of the largest programs has been the Fed’s purchase of Fannie Mae and Freddie Mac guaranteed mortgage-backed securities (MBS).  The program was initially announced in November 2008 with the goal of buying up to $500 billion, later expanded to $1.25 trillion.  Clearly we are talking a lot of money.

The ultimate objective of the FED MBS purchase program was, in the words of the Fed, to reduce mortgage rates “relative to what they otherwise would have been.”  Did the Fed meet this objective?  According to a new study by Stanford University Economists Johannes Stroebel and John Taylor the Fed did not. 

More specificially, the professors “find that the MBS program has no significant effect.  Movements in prepayment risk and default risk explain virtually all of the movements in mortgage spreads.”  So while it is clear that mortgage rates declined over the time the Fed has operated the MBS purchase program, those declines were due to factors outside of the Fed’s control.

Professors Stroebel and Taylor only look at the claimed benefits of the Fed’s MBS purchase program, leaving aside the issue of cost.  Since any losses on MBS purchased by the Fed reduces the amount of funds transferred from the Fed to Treasury, these losses are ultimately borne by the taxpayer, as that reduction will have to be made up elsewhere.  With close to a trillion in purchases, even minor declines in value can result in large losses for the taxpayer.  For instance, a 5% loss in value would translate to $50 billion loss to the taxpayer.  Another good reason to audit the Fed.

Thursday Links

  • Doug Bandow:  “Congress has spent the country blind, inflated a disastrous housing bubble, subsidized every special interest with a letterhead and lobbyist, and created a wasteful, incompetent bureaucracy that fills Washington. But now, legislators want to take a break from all their good work and save college football.”

Does CRA Undermine Bank Safety?

A recent policy forum here at Cato discussed the role of the Community Reinvestment Act (CRA) in the financial crisis.  While the forum focused on the federal push for ever expanding homeownership to marginal borrowers, the analysis did not touch directly upon the question of whether CRA lending undermines bank safety.

Fortunately this is a question that one economist at the Federal Reserve Bank of Dallas bothered to ask.  While his research findings were available before the crisis, they were clearly ignored.

In a peer-reviewed published article, appearing in the journal Economic Inquiry, economist Jeff Gunther concludes that there is “evidence to suggest that a greater focus on lending in low-income neighborhoods helps CRA ratings but comes at the expense of safety and soundness.”  Specifically he finds an inverse relationship between CRA ratings and safety/soundness, as measured by CAMEL ratings.

In another study Gunther finds that increases in bank capital are associated with an increase substandard CRA ratings.  Apparently bank CRA examiners prefer that capital to be lend out, rather than serve as a cushion in times of financial distress.

Given the current attempts in Washington to expand CRA, it seems some people never learn.  One can always argue over how CRA should work, but the evidence is quite clear how it has worked, once again proving: there’s no free lunch.

Remembering the Reporter Who Sued the Fed

With the Washington Post and other mainstream media outlets publishing endless defenses of “Federal Reserve independence” and proclaiming the Fed as savior of our financial system, it is all to easy to dismiss much of the media as simply defenders of the status quo.  There were many, however, willing to challenge this orthodoxy.  Standing out among them was Mark Pittman, reporter for Bloomberg.  It was Mr. Pittman who sued the Federal Reserve, winning a victory on August 24, as the Manhattan Federal Court allowed the suit to proceed.  Sadly, Mark Pittman passed away on November 25th. 

Mark Pittman and his employer, Bloomberg News, sought details on the Federal Reserve’s numerous special lending facilities.  Which firms were getting loans, and for how much and at what terms?  These were all details the American public were entitled to, yet were denied by the Federal Reserve.  We all remember the Fed’s warnings that if AIG counter-parties were named, there would be market disruptions.  Yet, after much public and Congressional pressure, those firms were named, with no adverse market consequences. 

While Mark Pittman’s efforts will be greatly missed, his suit continues, as does the efforts by Rep. Ron Paul and others in Congress, to bring transparency to the activities of the Federal Reserve.

Monday Links

  • Nancy Pelosi: “The power of Congress to regulate health care is essentially unlimited.”