Government Intervention Won't Solve Problems

Federal Reserve Board chairman Ben Bernanke, in a speech to the American Economic Association on Sunday, acted as you might expect a custodian of the institution he heads to act — defensively. He downplayed the role the Fed's loose monetary policy from late 2001 through much of 2005 played in creating the housing bubble that most authorities believe precipitated the financial fiasco that exploded in late 2008. While he made some valid points, his recommendation that "the best response to the housing bubble would have been regulatory, not monetary," is too vague to be useful and ignores the role that regulatory bodies actually played in expanding the housing bubble.

Stanford economist John P. Taylor, in a short book published in 2009, laid almost the entire responsibility for the financial fiasco on the Federal Reserve, specifically on its failure to follow guidelines he promulgated (called the "Taylor rule" by economists).

Bernanke argued that a modified version of the Taylor rule, using inflation forecasts rather than present inflation values, would have yielded interest rates closer to the rates the Fed actually enforced. More tellingly, he notes that the rapid increase in housing prices began in 1998 or 1999, years before the Fed's loose money policy was implemented — though he acknowledges that the increases accelerated in 2004 and 2005, which "does not rule out some contribution from monetary policy."

The most important weakness in Bernanke's remarks, however, is in seeing more extensive regulation (is it coincidental that the Fed is actively seeking more regulatory power?) as the way to avoid future bubbles.

The housing and financial sectors were among the most heavily regulated sectors of the economy before the bubble.

As Bernanke and most scholars agree, relaxed lending requirements, including adjustable rate mortgages and no-down-payment mortgages, combined with exotic financial instruments in the secondary market, dominated by the government-sponsored enterprises Fannie Mae and Freddie Mac, were the key factors in the housing bubble.

Unfortunately, as the bubble expanded, the relevant regulatory agencies were aggressively urging banks to loosen their standards even further, even promulgating quotas for relaxed-standard mortgages. So the regulators worsened the problem rather than trying to correct it. It is difficult to see how passing more regulations would help, given that future regulators would be subject to pressure from members of Congress (the chief source of pressure for loosened standards in the past).

Nice try. Excessive government intervention on many fronts was the main cause of the bubble. It is unlikely to be the cure.

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