How Far Responsible Were The Policies Of The Federal Reserve For The 2008 Financial Crisis?

How far responsible were the policies of the Federal Reserve for the 2008 financial crisis?

In 2008 the world economy was in free-fall - credit markets seized up, unemployment soared and the confidence that underpinned the entire financial system evaporated. The narrative of the story is well known; the Federal Reserve's loose monetary policy coupled with the reckless lending of Wall Street helped fuel a housing and consumption bubble. With such easy liquidity, the 'animal spirit' took hold and Americans lived well beyond their means. Once the Fed raised interest rates, mortgage and debt repayments were no longer made, house prices fell and the bubble that propped up the US economy burst. With mortgages now underwater and rates of default increasing, Americans were badly in debt - confidence along with spending in the economy vanished. Moreover, the banks' pre-crisis exploits of securitisation, high leverage and excessive lending, coupled with the rapidity in which the economic situation was deteriorating, meant they no longer knew the value of their own balance sheets - trust and lending between banks disappeared. With consumers and firms unable (and probably unwilling) to borrow, demand fell, businesses laid off workers, inventories were reduced and America soon descended into the cycle of recession. But who is responsible for the crisis? No one party should bear full responsibility; to make such an assertion would be mere political grandstanding. The banks played their part, as did the Federal Reserve. The failure of deregulation and wider imbalances in the global economy also contributed. Yet, the extent to which either party contributed to the crash is a question often unanswered. In almost all interpretations of the crisis, the Federal Reserve is at the epicentre. This institution's main function in the economy is to buy and sell treasury bills (T-bills) which helps to set interest rates. If the Federal Reserve buys T-bills, money is injected into the economy, flooding the market with liquidity, thereby helping to reducing interest rates. If it sells T-bills, money is withdrawn from the economy, reducing liquidity and consequently helping to raise interest rates. In addition to formulating monetary policy, the Federal Reserve also has regulatory duties (which will be discussed separately). At the helm of the organisation was Alan Greenspan, once touted as a member of 'The Committee to Save the World', appearing on the cover of 'Time' magazine and hailed as 'The Maestro', he is now largely vilified and in some circles seen as responsible for the crisis. Appointed as Chairman in 1987 under the Reagan administration, Greenspan served 5 terms until being replaced by Ben Bernanke in 2006. The policies of these two men arguably helped shape and facilitate the financial disaster of 2008. Following the bursting of the 2001 technology bubble (the NASDAQ index fell by 80%), President George Bush announced a series of tax cuts - primarily targeted at benefiting the rich by reducing the top rate of income tax. Besides exacerbating the already growing inequality in the USA at this point the Bush administrations' fiscal policy did little to stimulate the economy. With so much spare capacity after the dot-com bubble, there was little incentive for firms to invest or for households to increase their spending given the high levels of uncertainty and lack of confidence in the economy. What's more, Bush's tax cuts shifted money away from those who were likely to spend it (the middle and lower social-economic classes) to those who were unlikely to spend it (the '1%', America's swelling wealthy elites). This worsened the already low levels of aggregate demand. In this regard, the Republicans ought to bear some responsible for the economic crisis. Their belief in 'trickle-down economics', were cutting taxes for the rich creates jobs for poor with everyone rising on the same wave, was flawed. After all, the real median income of Americans' had fallen from $52,388 in 1999 to $49,777 in 2009 whereas the top 1% managed to grab a larger and larger share of the pie. Potentially, a far more effective policy for stimulating growth would have been a tax cut for the middle and lower classes (or in fact, an increase in government investment in infrastructure or education). By putting more money in the pockets of a large number of people with unmet needs and desire; the resulting rise in demand and multiplier is likely to be much greater; thus helping to create more jobs. Whereas, by increasing the incomes of the rich (a small number of citizens with fewer unmet needs and a greater inclination to save, invest in the stock market or overseas) the increase in demand, and therefore in jobs, would be likely to be smaller. However, the Bush administration failed to learn this economic lesson from the Reagan era - a man how believed tax cuts could solve any economic problem. Indeed, the then President merely saddled America with even more national debt. Greenspan was in favour of these tax cuts. Before 2001, the US had been running a large budget surplus (sometimes at 2% of GDP) and there was a belief that if this fiscal prosperity continued then the national debt would soon be paid off. With no government debt there would be no treasury bills; thereby severely compromising the Federal Reserve's ability to implement monetary policy. In addition, the high price of oil (peaking at over $140 a barrel in 2008 from an initial price of approximately $20 a barrel in 2002) due to the political and economic uncertainty generated by the 2003 Iraq War, meant that the USA spent hundreds of billions of dollars importing oil. With this much money leaving the economy, aggregate demand was further weakened. This situation, with fiscal policy failing to stimulate growth in a weak economy, created pressure on the Federal Reserve to improve the fortunes of the US economy. The Federal Reserve's chosen medicine was to pursue a vastly expansionary monetary policy - buying T-bills to lower interest rates and increase liquidity. The reason behind this was clear; low interest rates mean firms and consumers can borrow money cheaply. Consequently, there should be more inclination to spend; thereby helping to boost consumer spending and investment (the relationship between interest rates and investment is known as the 'Marginal Efficiency of Capital' or MEC theory, which stipulates that as interest rates fall, investment rises). As a result, aggregate demand should rise. This ought to lead to an increase in output, meaning more workers are needed to produce more goods and services, leading to a fall in unemployment. Furthermore, as interest rates are lowered, foreign investors receive a lower rate of return on their funds invested in US saving accounts. As a result, the attractiveness of the US currency is likely to fall, which may lead to a devaluation of the dollar. As the price of the dollar falls relative to other currencies, US exports become cheaper and consequently demand for US exports should rise, and levels of imports should fall - this move towards a balance of payments equilibrium is thought to bring about a further rise in aggregate demand. However, in this instance, the Federal Reserve's reasoning was fundamentally flawed. Despite the effective interest rate being at below 2% in 2002, investment failed to significantly rise, with so much spare capacity and lack of confidence in the economy (confidence fell from 140 index points in 2001 to just 60 index points in 2003) firms had little incentive to invest and consumers were reluctant to spend. The US's trade deficit with China continued to widen from around -$100 billion in 2001 to over -$240 billion in 2007. Even with a weak currency, the US was always unlikely to be able to compete with China for exports whose comparative manufacturing advantage was vast. With China's average manufacturing wage at just over $1 an hour in 2000, compared to USA average manufacturing wage of around $15 an hour, USA's firms costs of production, and therefore the price of the goods they produce, were destined to be uncompetitive. Instead of helping to stimulate long run sustainable economic growth, the Federal Reserve's loose monetary policy helped to create a housing bubble which in tandem supported a consumption and commercial real estate bubble. With so much liquidity and easy access to cheap credit, Americans borrowed excessively, by 2007 the average American household had over $19,000 debt and saving rates fell to practically zero - Americans lived far beyond their means. Indeed, before the crash, the bottom 80% of Americans were spending 110% of their income; this was unsustainable, but instead of reigning in their spending, the 'animal-spirit' took hold and Americans continued to borrow, mostly against their own mortgage in the belief that the value of their home would continue to rise. Such confidence in the housing market was misplaced, although understandable, given that the US house price index had risen from 100 index points in 2000, to approximately 190 index points in 2007 at the peak of the bubble - however, rationality soon returned. In 2006, the new chairman of the Federal Reserve, Ben Bernanke, realised the bubble that he had inherited - although he had little scope to deflate it. By increasing interest rates, Bernanke hoped to dampen demand for housing, thereby helping to rein in house prices. Yet, due in part to the carelessness of regulators, the Federal Reserve included, and the greed of Wall Street, this rise meant homeowners were no longer unable to meet their repayments. Mortgage default rates and the number of foreclosures increased dramatically. Instead of a steady decline in house prices that Bernanke had hoped for, the bubble Greenspan helped orchestrate burst. Many Americans' no longer had any equity in their homes - their mortgages were underwater. Arguably, Greenspan had helped to exacerbate this consequence. Incredibly, in 2004 he encouraged Americans to take out variable rate mortgages before Bernanke took office, despite the rather obvious fact that interest rates could only realistically go up - this meant that when interest rates eventually did rise, homeowners were no longer able to repay. Had Greenspan not endorsed such behaviour, then perhaps the rise in the number of defaults, and the consequences of the crash, may have been less severe. There were other policies that the Federal Reserve could have employed to help prevent the housing bubble. Greenspan could have increased short term rates long before 2006, yet this rise would have had to have been austere; thereby undermining the Federal Reserve' policy of stable prices and employment. Despite this clear opportunity cost, a rise in interest rates may have caused a recession but could have perhaps helped to prevent a far deeper one - the bubble would have been burst earlier, when it was less inflated. What's more, the Federal Reserve could have used regulatory tools instead of monetary policy. It could have insisted a margin requirement for homeownership (essentially a deposit related to the market value of the house). This measure would have restricted the number of Americans able to afford homeownership, thereby dampening demand and helping to stabilise house prices. Yet, this would have been unpopular politically (despite the theoretical independence of the Federal Reserve, politics plays a role in the formulation of monetary policy) as it would have undermined the aspiration values of American society, not to mention risking the wrath of Wall Street, whose firms would be unlikely to take kindly to such heavy-handed regulation and essentially a cap on profits. Moreover, it would have contradicted Greenspan's own deregulatory impulses - he had resisted raising margin requirements on stocks in the 1990's. In addition, the scrutiny of bank checks could have been increased - this would have ensured that borrowers were realistically able to repay their mortgage and help prevent banks engaging in predatory lending and subprime mortgages. Aside from helping to halt the steep rise of house prices, this would have also helped to limit the 'collateral damage' triggered by the rise in interest rates. However, due to the 'special interests' influencing the policies of the Federal Reserve, any policy that could restrict the short term profits of the banks would have been unlikely to gain approval. In short, the Federal Reserve helped to facilitate and encourage the housing bubble. By keeping interest rates low for so long, coupled with lax regulation and Wall Street's voracity, a housing bubble was almost inevitable. Although, the Federal Reserve should not be held solely responsible for the crisis, its role cannot be ignored. Aside from the Federal Reserve, Wall Street, the home of America's financial institutions, should also be held accountable to some degree for the 2008 financial crisis. The practices, incentives and mentalities that dominated the activities of these firms were key to shaping the housing boom and helped to exacerbate the damage caused when the bubble finally burst. Arguably, such consequences were a result of the culture of these firms. High bonuses and the divorce between ownership and control helped to foster a short term, solely profit driven mentality. The famous innovation of Wall Street now directed energy at generating more and more fees, which would lead to greater profits. With such high rewards available, greed prevailed and non-market values were crowded out, as traders failed to consider the social costs their behaviour could cause. Undoubtedly one of the most prominent examples of this was the securitization of mortgages. Here, banks bundled together mortgages and sold them on to investors. In theory, this was meant to diversify and share risk but, in practice, the banks transformed risky subprime mortgages into AAA rated ones - this was modern financial alchemy at its most dangerous. Even the notion that securitization would diversify risks was flawed - after all, a change in interest rates would be likely to send all house prices in the same direction. These 'securitised' mortgages were then sold onto unwary investors, pension funds and governments across the world. Ironically, Americans ought to be grateful for the success of the banks in selling these products abroad, had they not, the recession is America would have been likely to be worse. Indeed, instead of exporting sound economic and political ideas, the USA was now an exporter of recessions. Moreover, the securitisation of mortgages severed the relationship between the lender and the borrower, which helped to incentivise bankers to carry out poor credit and risks assessments - after all, they would be unlikely to bear the cost of their behaviour, instead they passed on the risky products and by doing so, helped to generate more and more fees. These products helped to create a distortion in the economy as there was such imperfect information between the buyer and the seller - the buyer of the mortgage backed securities knew nothing about the borrower and would have arguably displayed more caution in buying such securities had they know of the predatory and subprime mortgage lending that the banks had engaged in. Indeed, this would have helped to restrict the growth of the mortgage backed security market from just over $2 trillion in 1996 to just under $7 trillion in 2007. As the market grew, banks were incentivised to sell more and more mortgages thereby allowing more securitization and greater fees. Had the market not grown to such a size, the housing bubble, and the damage caused when it burst, could have been limited - however, the bankers paid scarce attention to these externalities. Another way in which Wall Street helped to cause the 2008 financial crisis was through their lending practices. The banks failed to create a good mortgage product (set interest rates with predictable repayments). Instead they focused on mortgages with variable interest rates, high transaction costs and restructuring - this helped generate more fees for banks. By restructuring mortgages banks pocketed the transaction costs, helping to postpone the day of reckoning and keep their own balance sheets intact - this also facilitated the inflation of the housing bubble. Furthermore, the banks engaged in predatory and subprime lending. They convinced the most ill-educated and vulnerable members of society to take out a big mortgage - of which they had little ability to repay. The banks then pocketed the fees and passed the mortgage along the finance food chain through securitization, ridding themselves of the lousy mortgages and generating huge fees along the ways. The growth of this market was colossal. The share of sub-prime lending in the mortgage market rose from 2% in 1994 to nearly 26% in 2006. Such lending practices created huge demand for houses, thereby helping to inflate the housing bubble further. Furthermore, as this demand was financed by unsustainable (and in many cases unrepayable) debt, when house prices eventually fell, the number of foreclosures was huge - rising from 700,000 in 2000 to over 1.3 million in 2007 - as American's defaulted on their mortgage repayments. 'Liar' loans added to these problems. Here, mortgage originators were keen to sell the biggest mortgage possible (they received a fee and were unlikely to bear the consequences of a default) and the homeowner had little to lose - the non-recourse loan structure went homeowners could walk away from their debt. The incentives of the lender and buyers were perilously aligned; both parties lied, and were encouraged to lie, about their finances - helping to stimulate demand and inflate the housing bubble further. Clearly, these practices undertaken by Wall Street helped to create and to a certain extent, amplify the consequences of the crisis. Ironically, the innovation that Wall Street prides itself on helped to create the crisis. Instead of focusing on innovation that would improve the efficiency of the economy, Wall Street firms directed their efforts at circumventing regulation and taxation, as well as creating increasingly complex and risky financial products - for instance credit default swaps (CDS). In this type of derivative, a company sells 'insurance' against the collapse of another company - if the value of the insured bond fell, the company that had issued the bond had to put up collateral to convince the buyer that they could pay up in the event the company the bond was derived form did indeed go bankrupt. Therefore, a low bond price would suggest a high probability of bankruptcy. This gave rise to perverse incentives; buyers had an incentive in insuring the early demise of another. Indeed, given the lack of liquidity in these markets, banks were able to manipulate the price of the bonds. By