Better regulation of the banks, not the Fed, is needed—no matter what Ted Cruz saysby Avinash Persaud / February 9, 2016 / Leave a comment
The counter-revolution is here and it’s being led by one of the top candidates for the Republication Presidential nomination, Ted Cruz. After a major financial crisis, such as the one in 2008, the time is ripe for radical reform. Deluded cries of “this time is different” heard during the previous boom are replaced with angry shouts of “never again” as the bust unfolds. But the moment for reform is in the direct aftermath of a crisis. If this opportunity is not grasped, it soon submerges along with the memory of the hard-to-measure dynamics of the crisis and how it upended prevailing beliefs.
At that point, those stationed far from the crisis, those more politically motivated, or those too young to remember, find data that appears to invoke the old certainties. They propose more radical applications of the same ideas that were found wanting. The sign that this counter-revolution is here is the increasing repetition of the belief that the last economic crisis was caused not by a collapse in house prices and the nexus between housing, banking and the economy, as a measured analysis might conclude, but by the US Fed keeping interest rates too high for too long in the summer of 2008. Leading proponents of this idea, including Ted Cruz, conclude that it is the Fed, not the banks, that need to be on a tighter leash.
This argument—which can be summed up as “It’s the Fed, stupid!”—is that the collapse in US personal consumption occurred in 2008, while the housing crisis began a full two years before. During these two years, the impact on consumer spending was slight and no one anticipated the credit crisis snowballing into something bigger because only six per cent of bank assets were exposed to sub-prime mortgages. Proponents argue that the spending crunch in 2008 occurred at exactly the same time as monetary policy was “tightening.” By that they mean that there was a five-month period when interest rates were held at 2.25 per cent while inflation expectations fell by 1.0 per cent and so real interest rates rose.
What has sustained this argument, besides a deep-seated belief that government is the root of all evil, is that to see through it, you need to look at granular data and you may not know where to look. Across the 3,007 counties in the US, housing net wealth only fell in more than a fifth of counties by 2007. By 2008, housing net wealth was falling in more than four fifths of counties. Between 2006 and 2009, personal consumption fell by 20 per cent or four times the national average in the one fifth of US counties that suffered the highest decline in housing net worth. The timing and regional spread of the collapse of personal consumption closely matches movements in household net wealth.
Back in 2007, people were worried about the escalating housing crisis. I published a Financial Times op-ed, “Hold tight, the bumpy credit ride is just beginning” in August 2007 which explained that the repackaging, rating and securitizing of mortgage debt had sprinkled sub-prime mortgage debt right across the balance sheets of banks and investors and the uncertainty this would cause would have a far greater impact than that implied by the modest size of the subprime mortgage market. The editorial also pointed out that the de-risking that was underway could not be forestalled by simply cutting interest rates.
The relationship between real interest rates and consumer spending has been thoroughly tested and found to have a variability and lagged response that does not fit with a story that pins everything on a five-month squiggle when real interest rates rose to an unthreatening 1.25 per cent, within a 12-month period in which they fall by around 2.5 per cent and end up negative.
The Fed and other central banks are not blameless. Between 2006 and 2009, the OECD countries that suffered the largest declines in household spending (Denmark, Ireland, Norway, Portugal, Spain, Britain and the United States) were those that had the greatest increase in mortgage debt over the preceding ten years when regulatory and monetary policy was too loose. However, the lesson of the past is that we must give priority to breaking the mortgage dominance of our economies, using regulation to untangle the nexus of housing cycles, banking crises and economic recessions. Until we succeed, our central banks need the flexibility to respond to the crises that will come.