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Reserve credit expansion that provided the

holding mortgages saw reduced cash flows.

means for unsustainable mortgage financing,

Firms holding securitized mortgage bundles

and (2) mandates and subsidies to write riski-

(often called "mortgage-backed securities")

er mortgages. The enumeration of regrettable

additionally saw the expectation of continuing

policies below is by no means exhaustive.

reductions in cash flows reflected in declining

market values for their securities. Uncertainty

about future cash flows impaired the liquidity

Providing the Funds:

(resalability) of their securities.

Federal Reserve Credit

Doubts about the value of mortgage-

backed securities led naturally to doubts about

Expansion

the solvency of institutions heavily invested in

In the recession of 2001, the Federal Reserve

those securities. Financial institutions that had

System, under Chairman Alan Greenspan,

stocked up on junk mortgages and junk-mort-

began aggressively expanding the U.S. money

gage-backed securities found their stock prices

supply. Year-over-year growth in the M2 mone-

dropping. The worst cases, like Countrywide

tary aggregate rose briefly above 10 percent,

Financial, the investment banks Lehman

and remained above 8 percent entering the sec-

Brothers and Merrill Lynch, and the govern-

In the recession of

ond half of 2003. The expansion was accompa-

ment-sponsored mortgage purchasers Fannie

2001, the Federal

nied by the Fed repeatedly lowering its target

Mae and Freddie Mac, went broke or had to

for the federal funds (interbank short-term)

find a last-minute purchaser to avoid bank-

Reserve System

interest rate. The federal funds rate began 2001

ruptcy. Firms heavily involved in guaranteeing

began aggressively

at 6.25 percent and ended the year at 1.75 per-

mortgage-backed securities, like the insurance

expanding the

cent. It was reduced further in 2002 and 2003,

giant AIG, likewise ran aground. Suspect

in mid-2003 reaching a record low of 1 percent,

financial institutions began finding it difficult

U.S. money

where it stayed for a year. The real Fed funds

to borrow, because potential lenders could not

supply.

rate was negative--meaning that nominal rates

confidently assess the chance that an institu-

were lower than the contemporary rate of infla-

tion might go bankrupt and be unable to pay

tion--for two and a half years. In purchasing-

them back. Credit flows among financial insti-

power terms, during that period a borrower

tutions became increasingly impeded by such

was not paying but rather gaining in propor-

solvency worries.

tion to what he borrowed. Economist Steve

Given this sequence of events, the expla-

Hanke has summarized the result: "This set off

nation of our credit troubles requires an

the mother of all liquidity cycles and yet anoth-

explanation for the unusual growth of mort-

er massive demand bubble."

gage lending--particularly nonprime lend-

The so-called Taylor Rule--a formula de-

ing, which fed the housing bubble that burst

vised by economist John Taylor of Stanford

--leading in turn to the unusual number of

University--provides a now-standard method

mortgage defaults, financial institution

of estimating what federal funds rate would be

crashes, and attendant credit-market inhibi-

consistent, conditional on current inflation

tions.

and real income, with keeping the inflation

There is no doubt that private miscalcula-

rate to a chosen target rate. The diagram

tion and imprudence have made matters

below, from the Federal Reserve Bank of St.

worse for more than a few institutions. Such

Louis, shows that from early 2001 until late

mistakes help to explain which particular

2006 the Fed pushed the actual federal funds

firms have run into the most trouble. But to

rate below the estimated rate that would have

explain industrywide errors, we need to identi-

been consistent with targeting a 2 percent

fy policy distortions capable of having indus-

inflation rate. A fortiori the Fed held the actu-

trywide effects.

al rate even farther below the path, consistent-

We can group most of the unfortunate

ly targeting stability in nominal income (see

policies under two main headings: (1) Federal

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