Tuesday, October 20, 2015

Projecting instability

Ben Bernanke has been talking about his new book, and he was recently on the Diane Rehm Show (HT: ThomasH ).  I thought his answer to one question was telling:


  • 11:29:44

    REHMIt's remarkable that you said that the recent financial crisis was the worst in human history, even worse than the Great Depression. But that's where I think an awful lot of people wonder, if it was so big, why didn't you see it coming and why couldn't you have done something to stop it before it happened?
  • 11:30:18

    BERNANKEWell, again, we were aware of the fact that house prices were very high. And we thought it quite possible that they would correct at some point. By 2006, 2007, we also were aware of the problems in the subprime lending market. What we did not anticipate and no one anticipated was the vulnerability of the financial system overall to a run, a panic.
This is sort of the last domino to drop in the logical steps that happen once you question the housing bubble narrative.  What if there wasn't a bubble?  What if home prices and returns were roughly in line with substitute investments?  The series of realizations that must follow affirmative answers to those questions ends with the conclusion that we really had to take a hammer to our own heads in order to get to a place where home prices collapsed.  With each passing month of newly accelerating home prices and rents across the country back toward equilibrium levels with a barely functioning mortgage market, this realization becomes stronger.

But, notice how Bernanke talks about houses in 2006 and 2007.  And, I really don't need to single him out.  This is the consensus view.  First, he says that house prices were very high.  Is that what the Fed is supposed to do?  Are they supposed to manage the prices of financial securities and real assets?

Then he says, "And we thought it quite possible that they would correct at some point."  Correct.  The price collapse was a correction.  An adjustment to something more appropriate.  The solution to a problem.  They were "aware of the problems in the subprime lending market."

Very few subprime loans were issued after 2Q 2007.  Home prices were still near their peak in 2Q 2007, and were just beginning to collapse.  By early August 2007, Jim Cramer was screaming on CNBC, begging for some liquidity.  The panic happened before the collapse.  When Cramer lost it, homes were only 4% off the peak, but they were falling by about 1% per month.

There was a panic, but the Fed did little to stop it, because home values falling by 1% per month was "correct".  So, did homes need to correct, and we were surprised that it led to a bank panic?  Or, were homes priced reasonably, and our financial system was operating carefully enough that it took a banking panic to pull home prices down?

I don't mean to be hard on Bernanke, either.  If the Fed had acted to stop the banking panic and home prices had stabilized or risen, he would have been pilloried.  Even after waiting more than a year to stabilize the economy, when the "financial crisis was the worst in human history, even worse than the Great Depression", the most vocal complaints were about being too friendly to the banks.


  1. The thing I hate the most about all of this is the "macroprudential" piece. It's bad enough to imagine the government managing asset prices, "correcting" them if they get "very high". Why does the government assume it knows better than private investors investing their own money?

    It's even worse for the Fed to attempt to regulate asset prices with monetary policy, which is a blunt tool. If used to "correct" asset prices, you might wind up with little side effects, like a depression. Swatting at mosquitoes with a hammer seems smart until you discover fractured skulls.

    What complicates all of this is the "moral hazard" of the banking system, where bank asset managers invest depositors' funds yet have the Fed to bail them out if things go south. I have never understood why we allow this. As long as people are investing their own money, we can let the markets be. Why not require 100% reserves?

    Yes, I am admitting that I do not understand fractional reserve banking in a fiat money regime. Sure, if you're stuck with a gold standard, I can see the temptation to "multiply" money as a form of monetary expansion. But in a fiat system? Monetary expansion is trivial. You, um, print more. So why do we have bankers at all? Why not the alternative of a 100%-reserve payment system? If people don't like paying for banking services, fine, have the government pay IOR as a subsidy.



    1. There is still a large role for a professional class of local lenders who take credit risks on productive investments, I think.

      A lot of this might be solved by getting rid of the FDIC and allowing a private deposit insurance system to develop.

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