Saturday, January 09, 2010

Dr. Hoenig, the Hawk: We Need More of Them

Dr. Thomas Hoenig, President of the Kansas City Federal Reserve Bank, has been known as a monetary policy hawk in the past. If he has been part of the Federal Open Market Committee's consensus supporting negative real interest rates, he is a dove no longer. He told the American Economics Association (AEA) meetings, “Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future.” Amen!

Hoenig vs. Bernanke

Hoenig and our current Fed Chairman, Ben Bernanke offered opposing views of history at the AEA meetings.

As George Santayana taught us, "Those who cannot learn from history are doomed to repeat it." So at issue is what role monetary policy played in creating the real estate bubble that caused the so called Great Recession of 2007-9. To Hoenig and to me it is clear that the over-expansion of credit that inflated the bubble had as its root cause the Fed's war against the paper dragon of deflation. Negative real interest rates in 2002-2005 and much too low rates in 2006 subsidized the creation of ever more esoteric securities which was the stuff from which Wall Street's leverage binge was made.  Negative real interest rates inflate investment bankers' profits and bonuses, misdirect productive resources into speculation, cause a dangerous correlation of returns, and subsidize the ever increasing financial roundabout production we saw during the recent bubble. Short term interest rates are the price for the raw materials with which investment banks create leverage in securities markets and financial engineers manufacture designer securities.Subsidize the raw materials and increase the supply.

Bernanke is a better student of the Great Depression of the 1930s than of the recent bubble. As John Cassidy relates, that Ben Bernanke "[r]ather than conceding that he and his predecessor, Alan Greenspan, made a hash of things between 2002 and 2006, keeping interest rates too low for too long, he said the Fed’s policies were reasonable and the main cause of the rise in house prices was not cheap money but lax supervision." Cassidy is moved to wonder in the Financial Times whether Ben Bernanke is "Decended From the Bourbons?" recalling "Talleyrand’s quip about the restored Bourbon monarchs: 'They have learned nothing and forgotten nothing.'

1 comment:

Anonymous said...


As we've discussed before, I find it useful to distinguish between Fed-provided liquidity and liquidity that is a state of mind in the markets, demonstrated by lenders' and investors' willingness to commit capital to certain markets. The housing boom clearly had more than its share of the latter kind of liquidity. I believe it will be a long time, however, before lenders readily extend credit to borrowers simply because they can fog a mirror and write a made-up amount of income on a piece of paper, even with the federal funds rate policy target at almost zero percent. "Humpty Dumpty" fell off the wall and not even Time Magazine's Person of the Year, Ben Bernanke, can put him back together.

I think it is certainly fair to assert that the Fed's monetary policy in 2003 and 2004 created a necessary condition for lenders to profitably offer super-low rates on ARMs to borrowers, but it is quite another to lay all of the sufficient conditions at the Fed's doorstep. Sufficient conditions I have in mind include relaxed credit standards (in terms of documentation, required creditworthiness, required down payments, acceptable loan-to-value ratios, etc.), members of Congress and the Bush Administration cheering on rising homeownership and Fannie and Freddie as they held more loans on their balance sheets (subprime in particular), fraudulent borrowers, changes in the loan market that threatened to make Fannie and Freddie irrelevant, borrowers' willingness to engage in serial refinancings to avoid painful adjustments to their ARM rates, and perhaps the huge pool of global savings.

As I look over the past decade, I do not see the evidence of huge macroeconomic policy mistakes in either the core or total CPI inflation rates. I would agree that inflation's post-2003 performance versus Fed expectations is evidence enough of macroeconomic policy mistakes, but they don't seem major. I have trouble justifying a view that excess Fed-provided liquidity worked through the narrow channels of relatively few markets (e.g., those for oil, food, and housing). The Fed's performance as a regulator is another matter entirely.

If the Fed is now making some big mistakes that will produce excesses, I would like to know where to expect to see the excesses show up in the coming years. Perhaps the specific consequences of the Fed's current policy is an appropriate topic for future commentary? At this point, I'm not convinced that our recent economic history will repeat itself or that it will even rhyme (apologies to Mark Twain).

Your friend, Bob