Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?

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Many commentators have argued that if theFederal Reserve had followed a stricter monetarypolicy earlier this decade when the housing bubblewas forming, and if Congress had not deregulatedbanking but had imposed tighter financialstandards, the housing boom and bust—and thesubsequent financial crisis and recession—wouldhave been averted. In this paper, we investigatethose claims and dispute them. We are skepticalthat economists can detect bubbles in real timethrough technical means with any degree of unanimity.Even if they could, we doubt the Fedwould have altered its policy in the early 21st century,and we suspect that political leaders wouldhave exerted considerable pressure to maintainthat policy. Concerning regulation, we find thatthe banking reform of the late 1990s had littleeffect on the housing boom and bust, and that themany reform ideas currently proposed would havedone little or nothing to avert the crisis.

Commentators have also argued that thepopularization of financial products such asteaser-rate hybrid loans for subprime homebuyersand credit default swaps for investors is toblame for the financial crisis. We find little evidencefor this. Housing data indicate that themajority of subprime hybrid loans that haveentered default had not undergone interest rateresets, and the default rate for subprime hybridloans is not much higher than for subprimefixed rate loans. Concerning swaps, althoughtheir introduction may increase financial inflowsinto risky sectors, their execution through aclearing-house or regulation via other meanswould not necessarily have avoided the mispricingof risks in underlying contracts. Capital requirementsfor the credit default swaps that wereused to insure mortgage-backed securities wouldhave been low because housing investments werenot considered risky.