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Wednesday, January 13, 2010

Did Low Interest Rates or Regulatory Failures Cause the Bubble?

In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernake has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.

Bank regulators didn't have the systems in place to prevent bubbles, they didn't see the bubble developing until it was too late to prevent major damage, and the systems needed to limit the damage were inadequate, e.g. there were insufficient limits on leverage and other protections in the system. By analogy, the Fire Department's inspections were inadequate and there was much more fire risk than anyone thought, they didn't notice the fire until it was already out of control (even though Dean Baker and others had tried to alert them), when they did notice and respond they were initially confused and didn't have the tools they needed to fight the fire or prevent it from spreading, and they hadn't thought to require protections such as automatic sprinkler systems that might have limited the damage.

What fueled the housing bubble? There were three main sources of the liquidity that inflated the bubble. First, the Fed's (and other central banks') low interest policy added cash to the financial system, second, the high savings in Asia, particularly China, along with cash accumulations within oil producing nations, and third, some of the cash was generated endogenously within the system (e.g. by increasing leverage or by diverting other investments into housing and mortgage markets).

Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.

I've been making this argument for some time, so is there any support for the idea that bubbles are fueled by excessive liquidity? In the video embedded below of Nobel prize winning economist Vernon Smith that posted today at Big Think, he notes that in the experiments he has conducted that reproduce bubbles in the lab, the existence and size of bubbles depends critically upon the amount of "cash slopping around in the system."

In the video, he also notes that if you ask a different question, why was this bubble so devastating as compared to the dot.com bubble even though the initial losses were smaller -- $10 trillion in 2001 compared to $3 trillion in the housing bubble collapse -- you get a different answer:  a failure of regulation. Here, he points to a failure to impose sufficient margin requirements as the key difference between the two episodes (I agree that leverage should be limited through margin requirements, and this would have helped to contain the damage, but I would have focused on the markets for complex financial assets rather than down payments on homes).

So I think the bubble itself was driven by "cash slopping around in the system" that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage.

[More from Vernon Smith: Taking a Hint from the Twenties, What Would Hayek Say?, A Little Inflation Would Do Us Good, Bernanke Didn’t See It Coming, The Next Wave of Derivatives.]

    Posted by on Wednesday, January 13, 2010 at 12:42 AM in Economics, Financial System, Monetary Policy, Regulation | Permalink  TrackBack (0)  Comments (97)


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