Reader ChrisB asks in response to yesterdays link to Anna Schwartz’s comment on the Federal Reserve:
In retrospect, what should the fed have done differently?
Risk and Return is really about implications for investment policy, and thus identifying which factors have implications is key. Pumping for particular policy choices really isn’t our role. Still, in identifying what probably should have been done we can better recognize the impact of future events. Here is the quick, and therefore somewhat inelegant, response I gave him:
First, I do think interest rates were kept too low, too long. The goal was to inflate asset prices, specifically housing, to stimulate the economy. Of course, high asset prices mean lower returns later, or in this case, declines. That worked, but what do you do next? The loans encouraged by high, and rising, prices don’t make sense when that condition clears.
The fear at the time was a deflationary spiral (see Japan since the end of the ’80’s.) The problem I had with that fear, and it was legitimate, was that for all the issues surrounding the tech and stock bubble (the latter not being over) Japan’s crisis was a financial, and specifically related to a real estate bubble, collapse. In order to avoid the Japan disease, we have put those very same conditions in place. The tech and stock market bubble collapse (once again, that collapse is still in process, and will be for some time) was unlikely to lead to a Japan scenario. I don’t think this will either, but it certainly has much more of a chance, which makes the policy much harder to defend. Recessions come and go, huge financial crises are not to be played with, even if the worst case scenarios are unlikely.
Second, if you are going to inflate housing, and in essence create a strategy for raising prices that may not be sustainable long term, it certainly makes sense to curb speculative excesses and fraud through regulation. I am no fan of regulation, but irrational prices encourage irrational greed. Doing what you can to ensure loan quality in this kind of environment was a no brainer. At minimum fraud needed to be curtailed. That wouldn’t have avoided the crisis, but it would have made it less severe. The Fed created conditions, it then needs to work to ameliorate the risks to the broader economy those artificial conditions create. Low regulation environments make sense when the ultimate investors and home buyers pay for their greed or mistakes. The discipline of the markets. However, if you create a situation where that solution causes broader systemic issues due to your own policy, the market will not work it out, because politicians and economic actors can’t afford for that many people to suffer.
To elaborate, moral hazard is in play. Politicians will try and fix it, leading to a spiral of further regulation and short term fixes, reinflating of assets and a rescue which encourages the same excesses. Worse, these solutions are unlikely to make much difference in the short term. Their impact will be after the current problems are likely to have worked themselves out systemically already. If they haven’t, the problem is therefore likely beyond the policies ability to accomplish much and will sow the ground for future crises from declining asset prices, that is if there are any assets left to inflate. Housing doesn’t seem likely to easily recover merely due to lowering rates again, and long run, do we want their prices to stay artificially high?
To put it another way, wasn’t using interest rates and a hands off regulatory policy in tandem to inflate housing values among the root causes of what got us here in the first place? If so, then stretching the pain out too much may help avoid a true Japan scenario, though I don’t think that is likely, but it is very likely to set us up for problems for years to come. I don’t envy Bernanke, his choices are pretty unappetizing all the way around at this point.
As an aside, I think this is a good time to read about Ben, here is a thorough biographical article by Roger Lowenstein that has taken the financial blog world by storm. (via Crossing Wall Street)
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