By Edward Chancellor
Published: January 10 2010 (Financial Times)
[Note: Mr. Chancelor is a member of GMO’s asset allocation team]
Academic economists and central bankers have long argued that asset price bubbles cannot be identified before they burst.
Furthermore, they deny that monetary policy is responsible for creating bubbles. It seemed likely the financial crisis, which followed an era of low rates and housing bubbles, would lead them to reassess these views. Yet despite the economic calamity, the Bernanke-led Federal Reserve has adopted a remarkably unrepentant line.
In his first speech of the year, Ben Bernanke commends policymakers (including himself) for their “forceful responses...that have] avoided an utter collapse of the global financial system.”
However, Mr Bernanke isn’t taking any responsibility for taking us to that brink. The prolonged period of low interest rates after the technology bust, he maintains, was justified because the recovery was weak and there was a risk of deflation.
Did ultra-low rates have the unintended consequence of inflating a housing bubble? Absolutely not, says Mr Bernanke. Given quiescent inflation, interest rates weren’t inappropriate. Besides, house prices started to take off in the late 1990s before the easy money era. The Fed chief cites a recent paper by his own staffers ( Jane Dokko et al, Monetary Policy and the Housing Bubble) that reports “only a small portion of the increase in house prices earlier this decade can be attributed to the stance of US monetary policy”.
The Fed researchers arrive at this institutionally comforting conclusion by using the same econometric models that failed to identify any connection between low rates and the incipient housing bubble at the time. These models have grandiose names, such as “vector autoregression” and “dynamic stochastic general equilibrium”, and employ complex statistical formulae that are beyond the comprehension of laymen. The fact these models were of no use in forecasting the financial crisis is conveniently overlooked.
The unrepentant central bankers also claim that the “setting of monetary policy [after 2002] appeared to follow the broad contours that would be expected given conventional macroeconomic views”. That these views denied the existence of the housing bubble at the time of its formation is also overlooked. In economics, apparently, it is better to fail conventionally than to succeed unconventionally.
Mr Bernanke’s compliant researchers find only a “tenuous connection” between low interest rates after 2002 and the housing bubble. Instead, they blame the housing boom on financial innovation – in particular, mortgage securitisation. They conclude that better regulation rather than a more restrictive monetary policy will prevent dangerous bubbles from forming in future.
The Fed has returned to its old view, maintained during the Greenspan years, that bubbles cannot be recognised ex ante. Nor does the Bernanke Fed accept that glaring macroeconomic imbalances that characterised the last decade – such as the rapid growth of private sector credit, the falling savings rate, and the gaping current account deficit of the mid-2000s – were useful leading indicators of an approaching crisis.
It seems incredible that Mr Bernanke and his colleagues have learnt so little from the recent calamity.
For a start, securitisation is unlikely to be a prime cause of the global housing bubble since home prices soared in many countries, such as Spain and Australia, which didn’t abound with exotic mortgage products. Given the dollar’s role as the global reserve currency, the Fed’s loose monetary policy had a far more extensive effect. Furthermore, housing bubbles are not difficult to spot. At GMO, we look at the ratio of home prices to median household income. When this ratio reaches two-standard deviations from the mean, we’re pretty confident a bubble has formed.
The connection between a loose monetary policy and asset price bubbles is pretty obvious to anyone with the slightest economic intuition: low rates make it cheaper to borrow, while acquisitions financed with credit drive up asset prices.
The Victorian economist Walter Bagehot was fond of repeating that “John Bull can stand many things but he can’t stand 2 per cent”. That is to say, when interest rates are very low people will be driven to speculate. Bagehot would certainly have understood that when the Fed Funds rate was cut to 1 per cent in 2003, a bubble in housing and other assets was likely to develop.