The Fed discovers Hyman Minsky
[Greg Ip] BEN BERNANKE’S meticulous argument on why the Fed’s monetary policy did not cause the housing bubble left largely unanswered a more interesting question: if low interest rates didn’t cause it, what did?
For that, you should read the Fed staff working paper that formed the basis for most of Mr Bernanke’s speech. It’s interesting not just for its content but what it says about how the Fed’s view of the world and how its mission may be changing.
There’s lots of interesting stuff in the paper, in particular on the lack of correlation between policy rates and housing prices in other countries. But most useful is the authors’ reconstruction of the forces that produced the bubble. They cite a self-reinforcing feedback loop of rising home prices, declining lending standards, financial innovation, and buyer euphoria. They explicitly endorse the models of Robert Shiller, a leading proponent of the role of psychology in bubbles, Charles Kindleberger, author of the classic “Manias, Panics and Crashes”, and Hyman Minsky.
While Mr Bernanke, in his speech, blames exotic mortgages for feeding the bubble, the working paper’s authors, Jane Dokko, Brian Doyle, Michael Kiley, Jinill Kim, Shane Sherlund, Jae Sim, and Skander Van den Heuvelgiven, are more nuanced:
The rise in the popularity of nontraditional mortgage features may have merely been a symptom of an underlying bubble mentality. While such mortgages allow borrowers to buy more-expensive houses, they do not necessarily make borrowers more willing to pay inflated prices. Rather, these products may have instead provided some support to house prices as they became unsustainable.
To be sure, the references by this paper to Mr Minsky and Mr Kindleberger are fleeting. Nor is the application of their insights terribly novel. Many of us have revisited (or discovered) Mr Minsky in our search for an overarching explanation for the bubble and crisis. But for the Fed staff, this is pretty radical. My own search of the Fed’s web site found only two previous references to Mr Minsky—one in a staff working paper, another in a speech in 2000—and just one to Mr Kindleberger. (Mr Shiller gets a lot.)
The prior negligence is understandable. Not only was Mr Minsky on the fringe of mainstream economics, his core insight is antithetical to the Fed. The Fed’s raison d’etre is stability: stable prices, stable employment, financial stability. But Mr Minsky argued that economic stability encourages more risk taking and leverage, and ultimately produces more instability and bigger recessions.
The Fed’s economists have traditionally personified the technical, evidence-based, progressive school of economics which holds that individuals are mostly rational, innovation is mostly good, and given sufficient examination and enlightened action, recessions can be avoided. This is one reason the Fed has traditionally been reluctant to assign a lot of importance to greed, fear and bubbles. This paper’s embrace of Mssrs Minsky, Shiller and Kindleberger may bely a subtle shift to a less utopian, more fatalistic view.
I detect the same shift in a recent paper by Karen Dynan, who recently joined the Brookings Institution after a long period on the Fed staff. At the Fed, she and co-staffers Daniel Sichel and Doug Elmendorf (to whom she is married, and who now runs the Congressional Budget Office) wrote an influential (that is, frequently cited) paper that found consumer spending had become much less sensitive to fluctuations in income. They attributed this to financial innovation which enabled families to use credit to sustain consumption even when income dropped. The paper portrayed financial innovation as good not just for individuals but for social welfare by contributing to the Great Moderation of business cycles.
Minsky probably would have argued that in helping consumers borrow their way out of short-term difficulties, financial innovation encouraged them to accumulate even bigger debt loads, to be resolved on an even more devastating day of reckoning. In her followup paper(http://www.brookings.edu/papers/2009/1204_household_financial_dynan.aspx), being published in the Journal of Economic Perspectives, Ms Dynan in essence acknowledges this, without recanting her earlier work:
The greater access to credit that has resulted from financial innovation has had both stabilizing and destabilizing effects on households. On the positive side, the expansion of credit card lending … home equity … lines of credit and cash-out refinancing …mean[s] that more households should be able to smooth their consumption across time… [But it] … exposed many of them to greater risk [of] significantly greater indebtedness, much higher debt payments relative to income, and substantially greater exposure to swings in housing and equity prices.
Technically, working papers don’t represent the official view of the Fed. But that disclaimer can probably be ignored in the case of Kiley et al, given its prominence in Mr Bernanke’s speech. And both Mr Bernanke and his number two, Donald Kohn, are philosophically and temperamentally closely aligned with the staff in a way that Alan Greenspan never was.
While I don’t expect either to start channeling Andrew Mellon and praising the purgative value of recessions, their views must be changing as well; Mr Kohn has already acknowledged several times that the Great Moderation contributed to complacency and risk-taking, and Mr Bernanke has acknowledged at least a theoretical role for monetary policy in attacking bubbles.
It’s true that Bernanke still seems reluctant to acknowledge his own failure(http://www.nytimes.com/2010/01/06/business/economy/06leonhardt.html?th&emc=th) to call the bubble. This is forgivable: no one seriously expects effective policy to revolve around foolproof bubble detection. Failure to shield the system against the potential consequences of a bubble is harder to defend. Tighter underwriting, capital and consumer-protection rules may not have prevented a bubble. But they would probably have mitigated the human pain and perhaps spared the financial system as serious a crisis, without requiring the Fed to take a stand on whether a bubble existed. The Spanish and Canadians have shown it’s possible. Mr Bernanke acknowledges the greater role for regulation in his speech. As a next step, he should apply the same forensic scrutiny to the Fed’s pre-crisis regulatory policy that he just did to its monetary policy.
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