Ben's impotent interest rates By Hossein Askari and Noureddine Krichene
With his senate confirmation for a second term as a chairman of the US Federal
Reserve Board delayed, Ben Bernanke took time to attend the annual meetings of
the American Economic Association (AEA) in Atlanta on January 3. His
pronouncements, however, must have confused many of those at the meetings as he
tried to convince his audience that the low interest rates that had been
engineered by the Fed during 2002-2004 had no part in fueling the housing
In response to the 2001 recession, the target federal funds rate had been
lowered from 6.5% in 2000 to1.75% in December 2001, and to 1% in June 2003.
After reaching a record low of 1%, the
target rate remained at that level for a year. The Fed could not keep interest
rates at such a low, as illustrated by the current near-zero interest rate
policy, without massive liquidity injection. Most disappointing was his
assertion that the US Fed had no responsibility in producing the ongoing
financial crisis and that the housing crisis was purely the responsibility of
supervisors and regulators.
The Fed chairman's view in his own words was that: "Monetary policy from 2002
to 2006 appears to have been reasonably consistent with the Federal Reserve's
mandated goals of maximum sustainable employment and price stability. The
availability of exotic mortgage products proved to be quite important and, as
many have recognized, is likely a key explanation of the housing bubble. What
policy implications should we draw? The best response to the housing bubble
would have been regulatory, not monetary! Stronger regulation and supervision
aimed at problems with underwriting practices and lenders' risk management
would have been a more effective and surgical approach to constraining the
housing bubble than a general increase in interest rates. That said, having
experienced the damage that asset price bubbles can cause, we must be
especially vigilant in ensuring that the recent experiences are not repeated.
All efforts should be made to strengthen our regulatory system to prevent a
recurrence of the crisis, and to cushion the effects if another crisis occurs."
Admission of responsibility for the financial crisis would be devastating for
Bernanke's tenure as the Fed's chairman. With the rate of unemployment rate
having risen already above 10% and today firmly entrenched at the 10% level,
the government running the largest fiscal deficits in US history, and the
banking system bailed out at the cost of trillions in government bailouts,
raising any suspicion about Fed's responsibility would erode confidence in
Bernanke's ability to remain the key US financial policymaker.
Hence, Bernanke threw back to the AEA participants the same arguments he
presented to the US Congress: the housing bubble was caused by exotic mortgage
products, deterioration of underwriting standards, and no documentation of
loans; the appropriate policy response would be reforming and strengthening the
regulatory and supervisory framework.
He added that the Fed could not recognize bubbles; these were recognized only
in retrospect, which is after they burst, and therefore the Fed could not act
to prevent bubbles. Simply, blame it on regulators. Instead, Bernanke claimed
credit for bailing out banks and was portrayed by many as a savior.
Bernanke and his predecessor at the Fed, Alan Greenspan, have powerfully
advocated the proposition that there is no relationship between monetary policy
and asset bubbles. This view clearly assumes that interest rates are totally
impotent. Greenspan and Bernanke opposed any tightening of monetary policy when
housing speculation intensified, despite repeated calls from Edward M Gramlich,
a former member of the Board of Governors of the Federal Reserve, and some
prominent economists for a tightening of money policy with a view to stemming
Greenspan had previously opposed any tightening of monetary policy when the
stock market bubble was gaining strength in 1987 and in late 1990s until the
market crashed of its own force. He had repeatedly dismissed any responsibility
in the current financial crisis. The Fed role was only to bail out banks and
inject money when bubbles burst.
Such policy became known as Greenspan-put, encouraging banks to engage into
speculative credit expansion, knowing full well that the Fed would bail them
out. Adamant opposition by both Greenspan and Bernanke to any tightening of
monetary policy for curbing credit expansion has undoubtedly turned out to be
disastrous for the US economy, with the effects of the crisis expected to
continue for many more years.
Bernanke's pronouncements, designed to protect his legacy, make little sense.
How can there be no relationship between interest rates and bank credit? How
can he seek to refute the fundamental role for a central bank to use interest
rates as an instrument of policy for limiting credit, inflation, and balance of
payments deficits? Indeed, the central bank has been endowed with instruments
for regulating the money supply and credit. Basically, these instruments are
the rediscount and advances, reserve requirements, open market operations, and
interest rate setting.
The central bank ought to deploy some of these instruments for managing
liquidity and restraining credit expansion. Bernanke has forgotten two basic
aspects of the banking system: interest rates and credit on one hand, and
banking regulation and supervision on the other.
Interest rates and credit expansion, or contraction, are macroeconomic
variables that can be regulated only by monetary policy. Bank regulation and
supervision are a microeconomic responsibility. Supervisors and regulators
analyze the balance sheet of one bank and ensure its compliance with safety
standards. They have no control on money supply, credit, and interest rates;
they cannot issue policy recommendation.
Credit aggregates for all banks fall under the jurisdiction of the monetary
authorities. Banks could be perfectly compliant with supervision and regulatory
standards, and yet, they may all expand at the same time through the credit
multiplier, without violating safety standards, and run the systemic risk of
credit default, contraction, and general bankruptcies.
Banks create and destroy money. The simultaneous expansion of bank credit
turned out to be the major source of financial crises in the past. Irving
Fisher attributed the Great Depression to over-indebtedness, that is, over
credit expansion. Charles Kindleberger attributed it to cheap money, low
interest rates, and virulent speculation.
It is disappointing to hear a denial of the role of interest rates in credit
expansion by an expert of the Great Depression. According to Bernanke's stand
in Atlanta, one could conclude that interest rates, prices of shares, and
credit had no role in the Great Depression. Had there been vigilant supervision
and regulation, the Great Depression would have not taken place! All bank
crises in the 19th century would be attributable to faulty regulation!
Unfortunately, no banking system in the past, no matter how strictly safety
regulation was applied, would have been able to survive the expansionary
monetary policy that we have experienced in recent years.
It is not surprising to see Bernanke dismissing any relationship between
interest rates and housing prices. He has also repeatedly dismissed any
relationship between interest rates and commodity prices such as those for
gold, oil and food, and exchange rates. He attributed oil price inflation to
high consumption by China and India and restrained supply by the Organization
of Petroleum Exporting Countries. He also rejected any relationship between
interest rates and external deficits. Politicians believed his views. By
dismissing a relationship between interest rates and commodity prices, Bernanke
kept reducing interest rates when oil prices skyrocketed to US$147 a barrel and
food prices rose to riot levels as huge quantities of food were diverted for
ethanol production. Clearly, exorbitant oil and food prices crippled the world
economy and precipitated world economic recession.
The thrust of Bernanke's argument was that the housing bubble was caused by
exotic mortgage loans and erosion of underwriting standards. He has mistaken
the effect for the cause. These products were promoted and encouraged because
of cheap money. Very low interest rates and abundant liquidity pushed by the
central bank would necessarily increase competition among banks and hedge
funds, reduce the income margin of lenders, and force banks to seek higher
leverage to increase income, and to push their way into subprime markets
through various financial innovations to loan up their abundant liquidity.
In conducting monetary policy, Bernanke was solely interested in what is called
Taylor's rule, which considers the short-term relationship between interest
rate, unemployment, and inflation. It would appear that for Bernanke, any other
variable not appearing in Taylor's rule would be irrelevant and would not be
influenced by interest rates. Using a narrow inflation measure, the core
inflation that excluded energy, food, and asset prices, he forcibly argued that
monetary policy was appropriate in view of unemployment objectives but he did
not perceive that his policy had led to worst post-war financial crisis;
although seemingly appropriate in 2004 in relation to unemployment, it
unfortunately backfired and led to an unemployment rate exceeding 10% in the
longer run in 2009.
Moreover, extremely low interest rates led to worsening of the external current
account deficit to about 7% in 2006 and to more dollar liquidity placed by
foreign investors in US banks, and lowering interest rates and in turn
contributing to intensifying the housing bubble.
The controversy about monetary policy is an old one: whether the central bank
should follow a fixed rule or a discretionary policy. Proponents of the fixed
rule want the central bank to control monetary aggregates, ensure the stability
of the financial system, and not interfere with the price mechanism and
interest rate setting. Proponents of the discretionary rule, such as the Taylor
rule, think that the central bank was also created to achieve full employment;
it has to control prices, including interest rates; they worry little about the
control of monetary aggregates; for that reason, credit expansion has never
been a component of the Taylor's model.
The distortionary effects of interest setting and the inevitable bank failures
that credit expansion would entail are afforded little weight. The extreme
view, as clearly contended by Bernanke in Atlanta, denied any effect of
interest rates on financial stability or on variables such asset and commodity
prices and exchange rates.
Bernanke's cheap monetary policy continues to dominate US policymaking
regardless of its effects. He has called for a strong regulation of the banking
system so that a similar crisis does not occur again. Some politicians are now
calling for regulation of the Fed as a way to prevent financial crisis.
The lesson that Bernanke learned from the crisis and wanted us to learn was
that the regulation system was at fault and needed to be reformed. Recently,
Tom Hoenig, president of the Kansas City Fed, warned against keeping rates too
low for too long. He noted that "Experience both in the US and internationally
tells us that maintaining large amounts of stimulus over an extended period
risks creating conditions that lead to financial excess, economic volatility
and even higher unemployment at some point in the future." Hoenig rejected
Bernanke's argument that the Fed decision to keep rates low after the dotcom
crash did not contribute to the housing and credit bubble and stated that low
interest rates contributed to excesses.
Bernanke is committed to the same policy that has led to the current economic
and financial crisis. His near-zero interest rate will de-stabilize the
financial system no matter how improved and strengthened the regulatory system
becomes. Speculation has become rampant in asset and commodity markets.
Although he denies a link between interest rates and commodities prices, oil
and food prices have increased sharply in 2009 by about 70%. After crossing $83
a barrel, oil prices are heading toward higher levels and could constrain
economic growth yet again.
Near-zero interest rates will erode capital income, savings, and investment.
They provide free-lunches for speculators. A repeat of the seventies
stagflation, or the recent Japanese lost decade, are not out of the question.
The US economy could continue to suffer high unemployment, as in the 1970s,
until policymakers find out that easy money may not the solution. By spreading
confusion and absolving the Fed of any responsibility, Bernanke has only
undermined confidence in the ability of the Fed to manage money, stave off
speculation, and reduce the risks for financial instability.
Strengthening regulation is certainly a priority; however, perfect regulation
would be incapable of preventing the damage of cheap money and negative real
interest rates on the financial system, on the real economy, and on external
The concept of the Fed as an independent institution is totally blurred. Does
an independent Fed mean unlimited influence for the views of its chairman, as
in the case of Greenspan and Bernanke, or a Fed that can be protected both from
excesses of its chairmen as well as from politicians?
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.