The Federal Reserve’s role in the financial crisis

By Edwin Dean,
Posted Oct. 22, 2008, at 6:38 p.m.

Most economists, this one included, believe that the Bush administration’s economic policies are dreadful. Yet, in fairness, the administration may deserve less blame than its opponents allege for the current financial crisis.

Democrats blame Bush for the mortgage market collapse that triggered the financial crisis. They also blame him for the subsequent collapse of the market for complex new securities, which ensured that the crisis would be deep and widespread.

Yet Bush administration policies may not be largely responsible for the mortgage market collapse. Republican and Democratic commentators alike have neglected one plausible explanation of the collapse: that the Federal Reserve Bank, which is independent of the administration, followed lax monetary policies after 2002.

First, some background: Before 2002 the housing and mortgage markets were relatively stable, with few dramatic booms or busts. John Taylor, a respected Stanford University economist who worked in Bush’s Treasury Department for four years, believes that this stability arose from vigilant Federal Reserve monetary policy: During times of rapid inflation and strong increases in GDP, the Fed raised interest rates to damp down these trends; and in times of economic contraction, the Fed eased rates to stimulate the demand for housing and other goods.

If the Fed had remained loyal to these policies, then in 2002 as house prices and the GDP started rising strongly, it would have raised interest rates and generally tightened monetary policy. Instead, it followed an easy monetary policy.

As house prices continued to rise, delinquencies and foreclosures in subprime mortgages fell. According to Taylor, this decline encouraged mortgage lenders to issue more and more subprime mortgages, even though most subprime borrowers had poor credit ratings.

In 2004, in response to continued strong increases in house prices and GDP, the Federal Reserve finally felt it had to tighten monetary policy. And it tightened drastically: Within the next two years, the Fed pushed the key “federal funds rate” from 1 percent to 5 percent, causing the housing bubble to burst in 2006. House prices fell rapidly and foreclosures and delinquencies in the subprime market rose sharply.

So, instead of stabilizing the mortgage market, Federal Reserve policies may have destabilized it.

What implications can we draw from Taylor’s analysis? First, even if he is correct, mistakes unrelated to Fed policies might have added fuel to the mortgage market fire. For example, Republicans argue that the mortgage crisis was caused by Democrats’ pressure on banks to expand suprime lending rapidly. And Democrats assert that predatory lending, tolerated by the Bush administration, intensified the subprime turmoil. There is evidence to support both accusations — but it’s hard to assess how much fuel these two factors added to the subprime fire.

Further, even if Taylor is correct, the scope of his argument is limited. Mortgage market problems may have triggered the financial crisis. But it was the subsequent collapse of the market for complex new mortgage-backed securities that led to its current breathtaking dimensions. This collapse was due mainly to determined Republican opposition to the regulatory oversight that this market badly needed.

So Bush administration economic policies deserve much, but not all, of the blame for the current financial crisis. Yet these policies have been so bad overall that voters should reject them soundly.

How bad? President Bush has treated the federal budget like a boy treats a cookie jar: Forget about filling it, just reach for more cookies. He has presided over a giant surge in federal government spending, including military spending that rose mainly because he began the unnecessary, expensive, and bloody war in Iraq. The huge Bush tax cuts reduced federal revenues, benefiting the wealthy much more than poor and middle-class Americans.

By combining large tax cuts with dramatic spending increases, the Bush administration produced record federal budget deficits, leading to an 80 percent increase in the federal debt. These deficits, in turn, contributed mightily to our huge international trade deficits.

It is not too late for voters to reject the Bush policies: John McCain supports the key ones. McCain strongly backed the invasion of Iraq and he has become a belated — yet enthusiastic — convert to the view that tax cuts, especially for the wealthy, are the answer to any and all economic problems. So it is too late to reject Bush, but not to reject his policies. The effective way to reject them is to vote for Barack Obama.

Edwin Dean, an economist and seasonal resident of Vinalhaven, writes monthly about economic issues.

http://bangordailynews.com/2008/10/22/opinion/the-federal-reserversquos-role-in-the-financial-crisis/ printed on December 22, 2014