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Did the Fed Cause the Recession?

I have been more defensive of the Fed's actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target.

First, though, let me make clear that I do not share Bernanke's view that the Fed's low interest rate policy did not the cause of the financial crisis. He points to a global savings glut as the source of the liquidity that inflated the bubble, and regulatory failures that allowed that liquidity to become concentrated in high risk investments within the mortgage market. My view is that it wasn't one or the other, the global savings glut and the Fed's low interest rate policy worked together to provide the liquidity that fueled the bubble. I don't think that the Fed's policy was a mistake given what they knew at the time, and given the condition of the economy after the crash -- and that is, essentially, Bernanke's argument -- but I don't think it's correct to say that policy played no role at all in the financial crisis.

But the main problem was, as Bernanke suggests, a failure of regulation. But I don't think the Fed is the only one to blame for that mistake, the blame is much broader.

Let me explain. I don't want a Fed Chair who is all powerful, someone who can do whatever he or she wants with respect to monetary policy and regulation of the financial system. That's far too much power for one person to have, and does not accord with the intent to distribute power built into the Federal Reserve system. But, in essence, that's how the Fed worked under Greenspan, and it appears Bernanke, though trying to be more open to views from other members of the Fed, has similar powers over policy.

Greenspan would not allow new regulation to be imposed on the financial sector as those who tried to warn about the problems in housing markets and got nowhere (or were ridiculed) will attest. Bernanke was not among the few who were issuing warnings, but even if he had been the pleas for new regulation would not have been received well by Greenspan. The real problem was not Bernanke's failure to call for regulation, the problem was the structure of power within the Fed that would not allow those who did see problems to bring their arguments forward and provide the persuasive evidence needed to turn their concerns into action.

But there was another, bigger problem that drove Greenspan's views on regulation. Again, I don't want a Fed Chair who is all powerful, a maverick who can take the Fed wherever he or she wants. One of the constraints the Fed operates under, and this includes Greenspan, is that the policies that are enacted must be within the accepted bounds of the economic profession. A maverick that goes outside these bounds may be successful, but the howls from the profession would be loud and it's unlikely the Fed Chair would survive such an outcry. In any case, for the most part I'd prefer that that the Chair of the Fed follow accepted practices.

Greenspan was a hard-liner on regulation, certainly toward the tail of the distribution, but he was not outside what the profession believed. Economists, for the most part, believed that deregulation was good, that it had produced lots of valuable financial innovations. I can recall holding up a graph in class long ago showing how few bank failures there were the year before, there were hardly any, and asking if this was stifling progress in the financial area. My point is that Greenspan was doing exactly what most of the profession supported. Thus, when Bernanke also adopted a supportive stance toward deregulation, it was not as though there was a big debate within economics on this issue and he chose the wrong side. He simply thought what we all thought -- he was part of one big collective mistake the profession made. Had Bernanke been arguing strongly for new regulation, nothing would have changed (except his reputation today). Greenspan would not have welcomed or supported a call for new regulation no matter how hard Bernanke might have argued, and the broader profession would not have supported it either.

So yes, there is blame to be placed, plenty of it, but I don't think it should be concentrated as much as it is on Bernanke and the Fed (Greenspan may be a different story, but he was also going along with the majority of the profession, or at least the powerful voices in the profession at that time). The blame is on the entire profession, and those who study the structure of the banking industry and regulation in particular. Many of the economists who are the most critical today were among those supporting deregulation (or they said little or nothing about it).

Finally, as I've noted before, I have come to the same conclusion that Krugman states today, that the most important thing we can do is to reduce the effects that bubbles have when they pop. We may never be able to prevent all bubbles or other problems in the financial sector, but we can do a better job of making sure that the effects of these problems are minimized. I'd start with limiting leverage ratios, the 30 or more to 1 we saw prior to the crisis is much too high and dangerous to unwind when problems hit, and I'd also restrict the other side of that coin and increase capital requirements. The system was far too fragile before the crisis, and that's something that we need to fix.