Bob Murphy complained that an op-ed by David Henderson and Jeffrey Rogers Hummel is no longer available at Investor’s Business Daily. I found it at the internet archive, but because that isn’t always reliable I decided to archive it here.

Blame Federal Gov’t, Not The Fed, For Subprime Mortgage Problems


Posted 3/27/2008

Many prognosticators on the economy blame the Federal Reserve for the current subprime crisis. But a careful look at the evidence shows that monetary policy, whatever its faults, did not cause the subprime mess. At least part of the blame is on the feds, not the Fed.

Why do people judge the Federal Reserve, whether under Alan Greenspan or Ben Bernanke, to be a major cause of the subprime bust? They note how low interest rates were from 2002 through 2004 and make the classic mistake of using interest rates to judge monetary policy. If interest rates are low, they reason, monetary policy must have been excessively expansionary.

Years ago, Milton Friedman pointed out one problem with this reasoning by emphasizing the distinction between nominal and real rates. Nominal rates can be low because expected inflation is low, an indicator of tight monetary policy.

A second problem is that interest rates also can change as a result of real factors involving supply and demand. In short, the market ultimately determines interest rates.

While central banks are big enough players in the loan market (and the quintessential noise traders to boot) that they can somewhat push rates up or down, globally integrated financial markets reduce that ability.

Greenspan is therefore correct when he attributes the unusually low interest rates early this decade to a massive flow of savings from emerging Asian economies and elsewhere.

The better way to judge monetary policy is by the monetary measures: MZM, M2, M1 and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20% to nearly 0% by 2006. During that time, M2 growth fell from over 10% to around 2%, and M1 growth fell from over 10% to negative rates.

The Fed most directly controls the monetary base. Its year-to-year annual growth rate since 2001 fell from 10% to below 5% in 2006 and now is 2%. Also, nearly all of the growth of the monetary base went into currency, much of which is held abroad.

The banking deregulation of the early 1980s admittedly attenuates the Fed’s control over the broader monetary aggregates. But when all the measures agree, the message is clear: Monetary policy was not expansionary.

To see how the government contributed to the subprime mess, we must look at the feds, not the Fed. The feds helped create the problem in three main ways.

First, the federal government contributes to what economists call moral hazard — that is, people taking risks because they know that if things turn out badly, someone else will bear a large portion of the cost.

The federal government’s semiautonomous mortgage agencies — Fannie Mae, Freddie Mac and Ginnie Mae — all buy and resell mortgages. Of the more than $12 trillion in mortgages in existence, one-third of them are owned by, or were securitized by, Fannie Mae, Freddie Mac, Ginnie Mae, the Federal Housing and Veterans Administration, plus other government agencies that subsidize mortgages.

Although Fannie Mae and Freddie Mac are no longer government agencies, their status as government-sponsored enterprises causes people who buy their repackaged loans to assume an implicit federal government guarantee. Also, to the extent government views large lending companies and banks as “too big to fail,” it contributes to moral hazard.

For the market economy to function well, it needs to be a profit system and a profit-and-loss system, with the losses being the penalty for bad decisions.

The second way the feds contributed to the subprime mess was with a little-noted change in regulations by the comptroller of the currency in December 2005 that acted as the trigger.

Financial planner Less Antman has pointed out that the comptroller started requiring banks to require minimum payments on credit card balances, causing increases of at least 50% for most cards and as much as 100% on others. Many people who hold subprime mortgages are people for whom a higher monthly payment on a credit card would be a problem.

Imagine that you’re such a person and that before you always made sure you made your mortgage payments. With the new regulation, you instead make your credit card payment but miss your mortgage payment, a widely observed transformation in the traditional American delinquency pattern.

Thus the comptroller’s apparently small change in regulations had the unintended effect of causing some mortgage borrowers to default.

The third federal contributor to the subprime crisis is the Community Reinvestment Act. This act, first passed in 1977 and beefed up in 1995, requires banks to lend to high-risk areas that they otherwise would avoid. Those banks that fail to comply pay fines and have more difficulty getting approval for mergers and branch expansions.

As Stan Liebowitz, a University of Texas economist, has pointed out, a Fannie Mae Foundation report enthusiastically singled out one mortgage lender that followed “the most flexible underwriting criteria permitted.” That lender’s loans to low-income people had grown to $600 billion by 2003.

Its name? Countrywide, the largest U.S. mortgage lender and one of the lenders in the most trouble for its lax lending practices.

How ironic, then, that the same federal government, and many of its boosters, now attack Countrywide for following the very policies the government wanted earlier.

Without any further bailouts, the government could reverse some of the steps that led to this debacle. Will it? Not likely.

Hummel is an assistant professor of economics at San Jose State University. Henderson, a research fellow with the Hoover Institution and an associate professor of economics at the Naval Postgraduate School, is the editor of The Concise Encyclopedia of Economics.

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