Did Fed Low Interest Rates Cause the Credit/Dollar Crisis and Global Recession?
Carlos M. Pelaez
A counterfactual is an argument of what would have happened if events or policies would have been different than what actually happened in reality (Pelaez and Pelaez, Globalization and the State, Vol. I, 125). Most significant empirical economics consists of counterfactual analysis. One of the most important and hotly debated counterfactuals in history is that proposed by Milton Friedman and Anna Schwartz that the Great Depression could have been avoided if the Fed had engaged in lender of last resort policy (LOLR) in response to the contraction of money originating in the banking panic of the 1930s (Pelaez and Pelaez, Regulation of Banks and Finance, 198-200). Empirical analysis requires measuring the performance of the American economy with a rule of constant increase of the money supply proposed by Friedman that could have prevented the contraction of the 1930s. The major hurdle is that available data are what happened but there are no data of what would have happened or the counterfactual. Another counterfactual by Harold Cole and Lee Ohanion is if the economy of the United States would have returned to full employment in the 1930s, as many other large economies, if New Deal policies had not caused high prices by encouraging industrial monopolies and high wage rates by increasing unionization through the National Industrial Recovery Act of 1933 (NIRA) (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 214-217).The credit/dollar crisis and global recession poses a similar counterfactual: what would have happened if the Fed had not lowered interest rates on fed funds to 1 percent from June 2003 to June 2004. The Fed issued “forward guidance” in post-meeting statements of the Federal Open Market Committee (FOMC) that policy “was likely to remain accommodative for a ‘considerable period’” (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ). This guidance could have been interpreted that the Fed could maintain the 1 percent interest rate as long as required to dispel the fear of “destructive” deflation in the US and that other tools of quantitative easing could have been used to shift downwardly the yield curve (http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm cited in Pelaez and Pelaez, The Global Recession Risk, 93). Quantitative easing has been used in the current crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-62, Regulation of Banks and Finance, 224-7).
There are two major competing counterfactuals on the causes of the credit/dollar crisis. First, the regulatory view of Official Prudential and Systemic Regulation (OPSR) explains the crisis in terms of failures of financial markets (Pelaez and Pelaez, Financial Regulation after the Global Recession, 32-4, 155-6). The counterfactual with regulatory recommendations is that stricter OPSR would have prevented the crisis and recession. The Financial Services Authority (FSA) provides an interpretation of the origin, severity and duration of the credit/dollar crisis in the Turner Review (cited in Pelaez and Pelaez, Financial Regulation after the Global Recession, 155-6). The low interest rates resulted from high savings rates in countries such as China and Japan, inducing investment in government securities in countries such as the United States that lowered real interest rates (adjusted for inflation) from levels around 3 percent in the 1990s to 1.5 percent in the beginning of the new millennium. These low rates encouraged investors to seek higher yielding alternative assets. Voracious risk appetite of investors induced financial innovations such as structured credit products that used high leverage and careless assessment of credit risk. The growth of securitization after 1995 was in the form of a system of “originate to distribute” in which financial institutions originated credit to all sectors but primarily to households and the financial system. Original credit obligations generated in the form of exotic securities such as adjustable rate mortgages (ARM) were pooled in securities sold to investors and other financial institutions but with part kept by the originating banks. These securities imploded after the default of the initial credit affecting not only the investors in the securities but also the originating banks keeping part of the risk. OPSR would have prevented the lax credit standards such as NINJA mortgages (no income, no jobs and no assets) and exotic products such as ARMs.
Second, an alternative view posits that regulatory failure caused, deepened and prolonged the credit/dollar crisis and global recession. The FOMC lowered the Fed funds rate to 1 percent from June 2003 to June 2004 because of the fear of “destructive deflation” similar to that in Japan in the “lost decade” (Pelaez and Pelaez, International Financial Architecture, 15-18, The Global Recession Risk, 83-95, 208-9, 221-5). Deflation is much more of a rare event than recognized in the fear of deflation: Andrew Atkeson and Patrick Kehoe analyze panel data for 17 countries over more than 100 years finding 65 cases of deflation without depression and 21 of depression without deflation, concluding there is no empirical evidence for association of depression and deflation (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 201). In retrospect, “destructive deflation” was not a threat justifying near zero interest rates for long periods and the deliberate expectation-creating “forward guidance” of maintaining those levels indefinitely. Income is a flow obtained by applying a rate of return to wealth (Milton Friedman, A Theory of the Consumption Function, cited by Pelaez and Pelaez, Regulation of Banks and Finance, 219, Globalization and the State, Vol. II, 200). In simplified form, consider the stock of wealth to be worth $1000 with rate of return of 10 percent, then the flow of income is 0.10 x $1000 equal to $100. Another form of viewing this simple equation is that wealth, $1000, is equal to income divided by the interest rate, or $100/0.10. Assume that the rate of interest declines to 1 percent. Wealth would be perceived as $100/0.01, which is equal to $10,000 or ten times more than before the lower interest rate. The Fed target of fed funds at 1 percent and guidance of low interest rates indefinitely created the perception of permanently increasing wealth in real estate and financial assets, eroding the discipline in calculating risks and returns in decisions by individuals, business, government and financial institutions. Imprudent decisions were made on the false impression created by monetary policy that housing prices and financial assets such as commodity futures and emerging market stocks would increase forever. The world engaged in carry trades of shorting the dollar to buy commodity futures and emerging market stocks that eventually caused an all-time nominal high of oil prices at about $145/barrel and the current rise of futures prices of gold, copper and oil.
John Taylor finds support with econometric analysis that the low interest rates of the Fed caused a real estate boom in the US replicated in countries such as Spain and Charles Calomiris finds that the entry of Fannie Mae and Freddie Mac in subprime and Alt-A (or liar mortgages) coincided with the acceleration of that market from $395 billion in 2003 to $715 billion in 2004, reaching $1005 billion in 2005, with Fannie and Freddie remaining in that market after the decline of house prices in 2006 (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219). The former chief credit officer of Fannie, Edward Pinto, provided testimony to Congress that Fannie and Freddie purchased or guaranteed $1.6 trillion of nonprime mortgages (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 219-20, Financial Regulation after the Global Recession, 156). To be sure, the process of increasing house prices began in the 1990s (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ). Dwight Jaffee and John Quigley measure the prolonged and substantial subsidy of housing in the United States of $221 billion per year. Part of the subsidy was hidden from the budget in the hybrid public/private form of Fannie and Freddie. The regulatory error counterfactual posits that the credit crisis originated in four excessive types of stimuli in 2001-2004 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the implicit intention in the “forward guidance” of maintaining that rate indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings.
The alternative counterfactual is that the credit/dollar crisis and global recession would have been avoided had there not been these four government regulatory policy errors stimulating excessive housing construction and speculative carry trades. The low interest rate target of the FOMC of fed funds at 1 percent from June 2003 to June 2004 was followed by sharp increase reaching 5.25 percent by June 2006. Construction lags house purchasing decisions as developers plan projects, open new land, begin construction, market the projects and eventually deliver the houses. Decisions by prospective new homeowners are lagged while they obtain credit at conditions that are affordable relative to expected income, shop for the new home, make a final decision and close the deal. The low interest rate of 1 percent for fed funds in 2003-2004 processed through the housing subsidy probably causing the increase in housing prices of 15 percent in 2004 and 17 percent in 2005 (http://www.federalreserve.gov/newsevents/speech/bernanke20100103a.htm ) that brought the world economy to the precipice of the credit/dollar crisis and global recession. The increase of the target fed funds rate from 1 percent in 2004 to 5.25 percent in 2006 processed devastatingly through the financial and real estate markets probably constituting the tipping point to the global recession. The defense of the rollercoaster behavior of fed funds target interest rates requires proving the more dubious counterfactual that the world economy would have performed better than without wide swings in interest rates.
There are elements of the Nirvana fallacy of Harold Demsetz in current regulatory proposals. This fallacy consists of identifying imperfections in actual markets while attributing to the government omniscience in observing imperfections in markets and omnipotence in always correcting them with textbook precision for an improvement in social welfare (cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 133-7, 201, Government Intervention in Globalization, 81, Regulation of Banks and Finance, 18, Financial Regulation after the Global Recession, 11). OPSR finds alleged imperfections in behavior of consumers, investors and financial markets and institutions that can be cured in all cases by errorless regulation. The New Institutional Economics (NIE) argues that both markets and regulation can fail (Oliver Williamson cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43). Regulation oriented by the belief in an errorless government while in reality it created Fannie Mae and Freddie Mac could contribute to the frustration of economic growth and employment creation already endangered by the pressure on interest rates of (1) raising the fed funds rate again from zero; (2) selling the portfolios of MBS of $2.5 trillion held by the Fed, Fannie and Freddie equivalent to more than 20 percent of all outstanding mortgages; and (3) issuing new debt for financing trillion dollar deficits and refinancing debt rising to more than 60 percent of GDP. Credit crises are typically more benign than devastating debt crises. Policy and regulation should induce instead of frustrating innovation, growth and employment creation by the private sector.
(Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)