Is the low Fed Funds rate to blame?

by on October 21, 2008 at 6:21 am in Economics | Permalink

Consider that the Greenspan Fed maintained a
1.75% Fed fund for 33 months (December 2001 to September 2004),
a 1.25% for 21 months (November 2002 to August 2004), and
lastly, a 1% Fed funds rate for 12+ months, (June 2003 to June

Here is the link.  But no, I don’t side with Austrian Business Cycle Theory in citing loose monetary policy as the main factor in the artificial boom which preceded the crash.  I view the boom as having been fueled by new global wealth, most of all in Asia, and the liquification of that wealth through credit and the desire for additional risk.

Note that if an increase in real wealth fuels the investment boom, consumption can be robust or even go up at the same time as the rise in investment.  Now, in the boom preceding the current bust, was American consumption robust?  Sure.  If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here.  (Try a rebuttal here.)

Loose monetary policy did contribute to the bubble.  In that sense I would defend a modified Austrian theory.  But other reasons also suggest that monetary policy was not the main driver.  Money has a much bigger effect on short-term rates than long-term rates.  Even long-term real rates have only mixed predictive power over real economic activity, including investment.  The Austrians have never developed much of a theory of bubbles.  Ideally you would have a good bubble theory, with Austrian-like monetary factors stirring up the bubble even more.  But you can’t get away with pinning so much of the blame on the government, as modern Austrians are wont to do.  "Bubbliness" is a private sector imperfection and relabeling it as "government distorting price signals through monetary policy" doesn’t much change that.

1 josh October 21, 2008 at 7:26 am

You should do a blogging heads episode/debate with Arnold Kling. I could show it to my high school students. The world would be a better place.

2 Marcus October 21, 2008 at 8:00 am

If the investment boom had been driven mainly by monetary factors, investment would have gone up and consumption would have gone down, as explained here.

I don’t understand why you accept this claim? Total spending must equal total income, as Krugman says. More investment means less consumption.

But that assumes my income comes from withing ‘the system’ so to speak. What if I was printing up my own money? I could certainly expand my investments without decreasing my consumption.

What am I missing?

3 John Bailey October 21, 2008 at 8:31 am

We live in a mixed economy and the reasons for bubbles are mixed. However government sets the parameters. If the parameters are expansive then private actions will push to the limits prior to being reined in by reality. If limits are less “expansive” there is less room for a bubble.

In the current case, the subprime problem began with the New Deal mortgage guarantee, LBJ`s taking the guarantee off the Federal books and then the Clinton approval of sub-prime mortgages.

4 John Thacker October 21, 2008 at 9:06 am

“Bubbliness” is a private sector imperfection and relabeling it as “government distorting price signals through monetary policy” doesn’t much change that.

Bubbliness in housing values specifically has strong public sector components, namely zoning and land-use regulations, as Ed Glaeser’s work suggests. However, while regulations do seem to affect the likelihood and length quite strongly, if people are convinced that prices must rise they can rise nearly everywhere.

Still, the role of land-use regulation in bubbles is too often ignored; partially that’s because there’s so broad agreement in at least the principle of them because they can encompass so many goals, from environmental to aesthetic to simply increasing prices. Even people who oppose the particular regulations in an area (such as DC’s density-decreasing regulations) tend to favor different regulations. Also, of course, there’s local issues.

If Iceland, Germany, Spain, Arizona, California, Florida, Nevada, and northern Virginia had bubbles, but fast-growing Texas and North Carolina did not, perhaps rather than assault libertarianism it might make sense to ask what’s different about Texas and North Carolina. It could just be a lack of local confidence in ever-rising house prices, but there could be something there.

5 pants October 21, 2008 at 9:15 am

Is “loose monetary policy” the same thing as “maintaining interest rates at an artificially low level”?

6 Robert Olson October 21, 2008 at 10:33 am

It may not be a monetary bubble (which I said at my blog, though not quite as eloquently :P), but there can still be important parts that have been government driven. Like “forcing loans onto subprime mortgagers.”

I know that you have already covered things like the Community Reinvestment Act on MR, but it’s important to make the caveat that monetary policy is not government’s ONLY policy.

7 Don the libertarian Democrat October 21, 2008 at 10:46 am

Whether or not one accepts:
1) A big global pool of money that needs to be invested.
2) Easy money from the Fed.
The Spigot Theory, you turn these conditions on and you eventually get a bubble, don’t explain the crisis.
After all, it’s one thing to argue that these actions cause an increase in investment, it’s another to argue that they cause an increase in poor investment. What explains the increase in poor investment is the system of implicit and explicit government guarantees to intervene in a financial crisis.

8 meter October 21, 2008 at 10:56 am

Again, you blowhards can continue to incite the cheap “it’s all Clinton’s fault” mantra and/or the “It’s all because of the CRA!!!!” throwaway line, but oftentimes the answer is multidimensional. Strain your rightwing-addled minds for more than 5 minutes. It’s rewarding, I promise.

Especially John Bailey_who_has_it_all_figgered_out.

9 aaron October 21, 2008 at 11:10 am

When you pump money into a generally confused market, bubbles will inflate. In this case, it went into the only places money wasn’t scared away from recently; first housing, then commodities.

When it went into commodities, consumption expenses went up. This decreased the supply of eligible borrowers and increased the default risk on existing loans even before considering the fall in asset prices.

10 Anthony October 21, 2008 at 11:22 am

“Money has a much bigger effect on short-term rates than long-term rates.”

Have you not heard of “inflationary expectations”? The Federal Reserve signaled its commitment to inflating the currency by keeping interest rates low through the dot-com crash, so naturally long term rates fell, given the signal that short term rates would remain low for a long time in the future.

11 John V October 21, 2008 at 11:42 am


I thought Robert Murphy gava a nice response to your previous post of the ABCT which incorporated the importance of capital theory (something you don’t do)…and you have yet to respond to it or acknowledge it. I think you should. Murphy is obviously much more astute in Austrian Economics than you are, Tyler. I’m saying Murphy is necessarily right because of that but I do think his level of understanding on the matter deserves some consideration on your part in form of some acknowledgment in your subsequent posts on this.

I notice that on matters like ABCT, you seem very able and willing to open discussions but rather unwilling to continue a dialogue by addressing Austrian economists who respond to you.

12 Andrew October 21, 2008 at 11:48 am

John Thacker,

If you’d asked most of these people if they thought they seeking out risks, including the speculators and the sub-prime borrowers, I bet they wouldn’t have even understood the question.

If I asked the person I bought my house from if they’d considered beta before buying, I imagine them responding, “I used to live in a real dump, so this house was beta.”

13 Oskar Shapley October 21, 2008 at 12:07 pm

“the desire for additional risk”

make that “the obfuscation of real risk”.

14 Bob Murphy October 21, 2008 at 2:00 pm

Hi everyone,

Well, I was watching a Dane Cook show and he said he knew he’d made it when he was walking off a Penn State performance, and now I can say the same–I got a link from Tyler Cowen! My work is done here.

Anyway, for those who like falsifiable predictions, I used ABCT in an analysis [pdf] for a bank client back in July 2007. I think it was fairly prescient, especially since this was before the “credit crunch” set in. I’m not Peter Schiff or Roubini, but there were still plenty of supply-siders saying everything was fine back in July 2007. (I don’t know what MR was saying since I wasn’t a reader at the time.)

Final point: Obviously in my “sushi” article–the one Tyler links to in his blog post above–I am not proving that the Fed caused the housing bubble. But my point was to show that Tyler’s objection to ABCT by itself is fairly weak, since standard ABCT explains the very “problem” Tyler cites.

15 Greg Ransom October 21, 2008 at 2:08 pm

The artificial boom is over determined. There is no single cause, there are many causes.

But we can distinguish between ultimate causes and proximate causes.

The underlying ultimate cause which would have caused an artificial boom and inevitable bust without all of the other contributory causes is interest rates set below the natural rate.

But the size and shape of this boom and bust were determined by proximate causes such as the CRA, the Clinton Justice department, the new swap and insurance instruments, the terrible regulatory regime, the institutional structure of Fannie Mae and Freddie Mac, etc., etc.

It’s moronic to look for a “single” cause in the current environment, OR to attack any particular cause because it is one of many.

But it’s also moronic not to acknowledge that there is one ultimate underlying cause which supercharged all the rest — the interest rate policies of the Fed.

16 RZ October 21, 2008 at 3:17 pm

I really think that the individual consumers get off easy in such debates. There have been many people living off credit – buy what they want today w/out much thought towards how they will pay it off tomorrow. Maybe easy credit and little to no regulation made this easy for them, but it still boils down to the consumer buying beyond his/her ability to pay. Just because my credit card gives me a credit limit of, say, $30K, it doesn’t mean that I can afford to charge up to that much.

17 Pedro P Romero October 21, 2008 at 3:55 pm

The matter cannot be settled without engaging in an empirical endeavor. Hayek (1937) mentioned that phenomena as the business cycles is one of those that it is beyond the realm of the pure logic of choice. Now from my reading of the current events and speculations about causes of the crisis. I think that these can be find in:
a) Over-regulations and conflicting-regulations in the Housing sector. b) the loose monetary policy (2001-2004), c) the over-exposition by banks to the mortgage sector, d) herding behavior by home-buyers, e) specialists who were trading financial instruments that they finally did not understand very well.
To determine the most important or ultimate(proximate) cause logical consistency is just the first step that will not settled this issue.

18 Alan Brown October 21, 2008 at 10:03 pm

The inflation created by the Fed hit some sectors of the economy more than others.

Globalization kept wages and prices for many manufactured down. But commodities and housing soared. But these didn’t show up in the government-created statistic known as the CPI.

The assumption that inflation is only a problem when it starts to show up in the CPI is a faulty one. If one half of a balloon is tightly constrained and the other expanding like crazy, its still going to pop.

Had the Fed committed to keep the dollar stable relative to commodity prices, this fiasco would not have occurred.

There are other problems, such as sloppy lending standards, also made possible by government policy that help create this perfect storm, but the root cause of this mess is the Fed’s inflation.

19 Bob Murphy October 21, 2008 at 11:08 pm

BTW on my blog I am calling for suggestions on ways to look at the data to distinguish Tyler’s theory above, from the capital-consumption story. Of course the criteria I came up with so far will favor my theory and not Tyler’s, so that’s why I asking for input from others who think Tyler is right.

20 Bill Stepp October 22, 2008 at 7:03 am

Barkley Rosser writes:

While many bubbles have been fed by loose monetary policy, and certainly that policy helped stimulate the US housing bubble, Schwartz is simply wrong about the general statement. Did loose monetary policy cause the original tulipmania in 1636-37? Answer: No. There are plenty of other counterexamples.

Loose money had nothing to do with whatever happened there; but I don’t think it was a business cycle either. Neither was the hoola hoop craze in the early 60s, baseball card “bubbles,” etc.
I am aware that a couple historians have supplosedly adduced evidence that the tulip mania was like a business cycle, but then there are historians who claim that the Nazi’s gas chambers didn’t exist either. Do you believe them?

As for the laboratory “evidence” that bubbles, however that apparently very elastic term is used, exist under rarified conditions, this simply proves Schumpeter’s statement about how far from real science supposedly scientific habits of mind can get.
Giving a Nobel prize to Smith (and now Krugman) simply shows that it doesn’t actually mean anything.
It’s like the Oscars. At least actors have some talent (supposedly) to go along with their vinegar; economists don’t even have that.

21 Vangel October 22, 2008 at 2:07 pm

It seems to me that the Austrians have theories that do a good job explaining bubbles. Even the tulip mania can be described in terms of inflating the money supply as gold and silver flooded into the country and drove up general prices higher and higher. Tulips just happened to be the asset class that attracted extraordinary attention but it could have been something else entirely that turned into a bubble. For the record, the mania ended after the government ended the ‘free’ coinage of silver florins. It did not help the growers of tulips when the government cancelled all futures contracts and by doing so caused the price levels to drop even further.

This type of scenario has been played out throughout history and our housing bubble and toxic debt mess are the latest manifestation of government policies that expand the amount of money and credit and create an environment that readily accommodates speculation and malinvestment. In a truly free market environment any errors in judgement that created a bubble would have corrected long before it grew to a size that could threaten the entire economy. What we have seen is a failure of statism and the Austrians do a very good job of explaining it.

22 Stan Kwiatkowski October 26, 2008 at 6:43 am

@ Lord

But the question is: what caused the loose lending practices?

23 Jeff November 6, 2008 at 11:31 pm

also consumption went up b/c as investment in housing and thereby housing prices went up, people extracted more equity from there homes and went shopping like bush told them to…it was debt-based consumption, not real wealth consumption and people are paying the price now…it’s no coincidence that during 2001 mortgage debt as a % of GDP began to massively rise…also, the fed can only lower the funds rate by inflating the dollar, and it tried to reinflate the stock market bubble, but bubbles never reinflate, they spill into other markets what is exactly what happened what spurred the housing bubble

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