No Fed, No Destructive Housing Bubble
Yesterday’s Wall Street Journal had a nice short summary of how bad housing policy over several administrations misdirected greed (self interest or prudence) into actions by private actors that created the bad paper underlying the financial crisis. Unfortunately the authors, Gramm and Solon, greatly understate the role of the Fed in this calamity. My letter to the editors of the WSJ.
Phil Gramm and Mike Solon in “The Clinton-Era Roots of the Financial Crisis” make a strong case that “Affordable-housing goals established in the 1990s led to a massive increase in risky, subprime mortgages.” While anti-market forces point to “banks, greed, and deregulation for causing the financial crisis,” it was in fact the government created institutional framework driven by the affordable housing cabal that channeled self interest, which normal market competition guides into patterns of behavior which benefits market participants and society, into an unsustainable pattern of activity that culminated in the Great Recession and accompanying financial crisis.
Gramm and Solon correctly recognize the role of the Federal Reserve in the run-up to the crisis with its “too low, too long” interest rate policy which followed the Fed induced dot-com boom-bust of the late 1990s and early 2000s. They point out, “Everything appeared to work fine as long as accommodative monetary policy and capital inflows from developing countries continued to fuel the upward float of housing prices.” However they fail to realize that without that Fed accommodation there would have been no crisis and most likely, no recession and definitely no Great Recession. Economist Roger W. Garrison [here, 449] clearly states the synergy between Fed policy and the mortgage induced financial crisis:
Without the Fed, the impact of the distortions in the housing market would still have been significant, but they would also have been much more limited. The fact that the “Greenspan Fed adopted a loose monetary stance in the wake of the dot.com bust and well into the century’s first decade was a game changer. The accommodation freed the housing sector from having to draw investment funds from other sectors. It fueled an economywide boom—the housing bubble leveraged by practitioners of Modern Finance being the most dramatic aspect of it.” He concludes, “[T][he fact that the bubble was doubly artificial provided a strong hint about the difficulties inherent in the subsequent recovery.
John P. Cochran
Emeritus Professor of Economics and Emeritus Dean-School of Business
Metropolitan State University of Denver
P.O. Box 173362
Denver, CO 80217-3362