Fed Chairman Bernanke is up for reappointment next year, and the questions are beginning in earnest about how he’s handled monetary policy. Some of the best-informed people out there insist that the cause of the housing bubble and the subsequent crash was an episode of low interest rates during 2003 and 2004, as the U.S. economy was recovering from the post-9/11 recession. Alan Greenspan was the Fed Chairman at that time, but Bernanke was prominent among the Fed’s governors, and fully supported the loose policy.
It’s always fun to look into the past for someone to blame, but the more important question is what this means for monetary policy going forward. To a careful observer, there can be no question that the crisis had many causes, and was greatly exacerbated by complex interactions that no one could have predicted.
For their part (and I agree with them), Bernanke and Greenspan have both pointed many times to the “savings glut,” a vast accumulation of dollar reserves by the governments of emerging nations. Its effects have been apparent since the mid-Nineties, as the excess capital reduced interest rates and excess production reduced inflationary expectations. Did the savings glut make possible the burst of financial technology that greased the skids of the financial system? No, it didn’t. But without the glut, there would have been far less incentive to find clever (and ultimately unsustainable) ways to increase investment yields.
We haven’t had such a strong deflationary episode since the early Thirties. Bernanke was absolutely right in seeing that coming. (We had more than enough clues from the various financial crises of the Nineties.) I simply have a hard time believing that twelve months of expansive monetary policy in 2003-04 triggered a housing bubble that arguably started up almost ten years ago and peaked in 2006.
Bubbles are blindingly obvious in retrospect, but very difficult to see when you’re in them, as counterintuitive as that may sound. When markets are rising, everyone who doesn’t pile on gets left behind, and that matters, because they lose their clients and go out of business. Greenspan and Bernanke would have been crucified for raising rates in ’03 and ’04 and prolonging the recession we were just recovering from. It’s always easier for a policymaker to let the party run on too long. Their indecision during the critical 2005-06 period shows in contemporary remarks by Greenspan that housing looked a little “frothy,” but probably not enough to be of concern.
But the question now is whether loose monetary policy is again setting us up for a crash. To compare quantitative easing to the low-interest rate policy of late 2003, is a lot like saying that the ocean is like a mud puddle because both are wet. We’re witnessing an extraordinary pulse of money creation, specifically intended to avoid repeating the grave policy errors of 1928-1932, a much bigger undertaking than counteracting a cyclical recession.
Market participants are now nearly unanimous in fearing powerful inflation ahead, as a result of the Fed’s current policy, and also because they see trillion-dollar budget deficits for years to come. Markets are violently uncertain on exactly how much and when, as can be seen in the daily see-saw of medium-term interest rates, commodity prices, and the dollar exchange-rate. But still: when everyone agrees on something, you always have to ask what they’re missing.
The huge amount of money the Fed has created since last fall isn’t finding its way into the economy, and it isn’t fueling real inflation. (Things like crude oil and gold respond at least as much to market expectations as they do to reality.) The principal effect of all that excess money has been to repair the interbank lending markets, which are now looking quite close to normal. And this is a reminder that the Fed’s chief priority last fall was not the economy, but rather to prevent a financial meltdown. In this, they’ve succeeded commendably.
But what about the economy? What if final demand ticks up, and banks start putting money to work again? First off, it’s not a foregone conclusion that this is even possible. There’s no much wreckage in the financial system that no one really knows if the patient will start breathing on his own again, after the life support comes off.
But even if that does happen, the Fed has the tools to quickly wipe out huge amounts of excess liquidity. There are two questions: first, will they do it if/when the time comes? And second, will it matter?
The first, candidly, is a political question as much as an economic one. The government will doubtlessly apply pressure on the Fed to keep the party rolling, especially at a time when Bernanke is up for reappointment, and the historic independence of the Fed itself is being called into question.
But what if inflation appears, the Fed acts to quell it, and it doesn’t matter? This is a haunting and unanswerable question. The value of money is all about confidence. In history, hyperinflation has proved stubbornly unresponsive to actions by policymakers, especially in cases where those same policymakers were seen as the cause of the problem.
We’re in uncharted territory, and it’s quite impossible to confidently predict how things will go from here, either in regard to the course of policy or to the course of events.