Andy LaPerriere: Questions for the Fed


By Andy LaPerriere
The Wall Street Journal
Thursday, April 3, 2008

In recent months we've seen countless proposals introduced in Congress to protect borrowers from so-called predatory lending. On Monday, the Treasury Department announced a major overhaul of federal regulation of the banking and securities industries.

So far the policy debate has centered on predatory lending and lax bank-regulatory supervision. Hillary Clinton and others have gone so far as to say that subprime loans were "designed to fail." While that makes for a tidy political narrative complete with a villain, it is not a very complete picture of what is happening.

With companies like Bear Stearns and Countrywide (and many others) on their knees, it's clear that events have not turned out as their managements intended. Is it possible the root cause of the credit crisis -- which has not been limited to the mortgage market -- lies not just with a few sinister CEOs, but with broader policy mistakes by intelligent and well-intentioned officials at the Federal Reserve?

Mortgage lenders, home builders, real-estate speculators and millions of average people who borrowed too much were caught up in a mania. They were responding to misleading market signals that told them to write more reckless loans, build more houses and borrow as much as the bank would lend them. After all, people who did these things during the boom profited handsomely year after year.

If this all sounds strangely familiar, it's because the same kind of imprudent economic decisions and outright fraud occurred during the stock-market bubble just a few years ago. To be sure, there are many contributing factors to the recent housing and credit bubbles (and to the Nasdaq bubble), but a central ingredient in almost any mania is easy monetary policy.

The housing boom began in earnest when the Fed slashed interest rates in response to the 2001 recession, and kept rates too low for too long. The lower interest rates cut monthly mortgage payments and fueled the first wave of home-price appreciation, which began to take on a life of its own. Artificially low interest rates reduced returns on safer investments like government and corporate bonds, so investors moved funds into riskier assets (like subprime loans) to increase returns. Low interest rates also made it profitable to borrow heavily in order to invest in mortgage-backed securities and other financial assets, and leverage grew at a breathtaking clip.

Furthermore, the Fed's policy of ignoring asset bubbles on the way up but aggressively responding to cushion the blow when they inevitably collapse (widely know in financial markets as the "Greenspan put") caused investors to take on even greater risk. The adverse consequences of this loose monetary policy extend well beyond rising foreclosures and the other visible effects of the housing bust. The Fed's loose monetary policy has hurt the average American. Here's how:

-- Rolling asset bubbles have depressed wages by spurring unproductive investment, first in the tech and telecom sectors and more recently in housing. This has reduced the funds available for other, more productive investment that could have increased real economic output and raised wages and living standards. Austrian school economists call this "malinvestment," and it is an inevitable byproduct of credit bubbles.

-- The stock market and housing bubbles created windfall gains for some (who sold at the right time) and windfall losses for others (who bought at the peak). Many speculated or acted irresponsibly during both bubbles, and have reaped what they sowed. But others were innocent victims of the boom-bust dynamics. For example, young families who bought their first home in Florida or California during the past few years will suffer for years to come the economic consequences of buying at the peak of a historic bubble. (Proposals in Congress to offer temporary tax credits for purchasing homes would create more arbitrary windfall gains for a few at taxpayer expense, while doing little to alter the fundamentals of the housing market.)

-- The boom-busts have caused massive and unnecessary employment dislocation. Responding to market signals, many workers flocked to the tech and telecom sectors in the late 1990s and the housing-related sectors in recent years, only to earn a pink slip during the bust. Not only does this cause financial and emotional hardship, the waste of human capital hurts the economy overall. A flexible labor force is one of the great strengths of the U.S. economy, but policies that cause unnecessary dislocation are economically destructive.

-- The Fed's loose monetary policy is causing inflation and reducing the purchasing power of Americans' paychecks. Headline inflation is well above the Fed's target, and the reduced purchasing power is readily seen in the declining value of the dollar, and rising food and energy prices.

Today the Senate Banking Committee will hold a hearing and examine the details of Bear Stearns's rescue by J.P. Morgan. This rescue was brokered by the Fed, which as part of the agreement put $29 billion in taxpayer funds at risk. Fed officials will surely receive some tough questions regarding its role in this agreement, and rightly so. Policy makers ought to question the criteria the Fed used in making its decision.

But members of the Senate Banking Committee ought to ask a broader question: Has the Fed's approach to monetary policy during the last several years served the interests of average Americans?

Many will no doubt wince at the suggestion of "politicizing" monetary policy. But a sober review of monetary policy is not only sorely needed, it is Congress's responsibility. Federal law has long required the Fed to report to Congress every six months on its conduct of monetary policy. In recent years, a serious discussion of monetary policy has been almost completely absent at these semi-annual hearings, which have devolved into frivolous public relations forums where members of Congress try to get the Fed chairman to endorse their latest tax cut or spending program.

Congress should not try to fine-tune the federal funds rate any more than it should dictate which drugs the FDA approves. However, like the FDA, the Fed is a creation of Congress. Just as Congress has a legitimate and important responsibility to review the policy decisions that determine which drugs are approved, it should also scrutinize the broad policy framework the Fed uses to determine monetary policy.

The Fed has a very difficult job. Tight monetary policy risks recession, while loose monetary policy risks inflation and asset bubbles. Some Fed officials may be beginning to reflect on whether the Fed has struck the proper balance, as well as on the larger role monetary policy has played in the current housing and credit debacle. It's time for Congress to do the same.


Mr. LaPerriere is a managing director in the Washington office of ISI Group.

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