Introduction
In 2008, the entire world was rocked by the biggest financial crisis since the Great Depression. The crisis first affected the entire financial system of the United States before then quickly spread globally. The casualties of the crisis included the whole investment banking industry of the US. Other casualties were the US largest insurance company, largest mortgage lender, among other firms in the financial services sector. The US auto industry was severely hit leading to loss of jobs. The US unemployment rate increased by 4.9% points from the third quarter of 2007 to the third quarter of 2009. The stock market followed with the Dow Jones Industrial Average losing 33.8% of its value. By the end of 2007, the crisis had spread to Germany, China, Japan and other countries and the entire globe was in a great recession. Many questions have been asked about what might have caused the financial crisis. One cause that stands out is the ineffectiveness of the monetary policy. The monetary policy played a significant role in causing the 2008-2009 global financial crisis.
Role of monetary policy in the economy
Monetary policy involves the manipulation of aggregate money supply in an economy to achieve desirable macroeconomic goals. The monetary policy comprises actions taken by the central banks to regulate the money supply and interest rates in eth economy. In the US, the monetary policy is the duty of the Federal Reserve. The Fed can either use expansionary or contractionary monetary policy to achieve macroeconomic targets. For instance, during a recession, the Fed uses expansionary monetary policy to boost aggregate demand. This involves the use of open market tools as well as manipulating the interest rates and bank reserve requirements. Expansionary policy actions include lowering bank reserve requirements and lowering the interest rates. It also buys treasury bills and other government securities in the securities market. These actions increase the money supply in the economy thereby boosting the aggregate demand.
When there is inflation, the Fed uses contractionary monetary policies. The Fed can sell treasury bills and other government securities thereby reducing money supply in the economy. Alternatively, the Fed can raise the interest rate (Fed funds rate). This raises the cost of borrowing hence reducing the demand for loans in the market for loanable funds. A reduction in the demand for loanable funds also causes a decline in the purchasing power of consumers. Besides, the Fed can raise bank reserve requirements. This causes a reduction in the amount of money commercial banks can lend to their customers thus reducing money supply in the economy. A reduction in money supply causes a fall in the purchasing power of consumers thereby reducing demand-pull inflation.
The role of the monetary policy is critical for the stability of the economy. Fed funds rate (interest rates) and money supply affect all variables in the economy. They affect the demand for and supply of securities in the securities market. Therefore, monetary policy action affects the prices of securities. The monetary policy further affects the exchange rate. If the Fed increases the interest rate, the value of the US Dollar relative to those of other countries will increase. This is because international investors earn higher interests or returns on capital invested in eth US than in other countries where the interest rates are low. This results in an increase in the demand for dollars causing a rise in its value. The increase in the value of the currency will affect importers, exporters, domestic consumers and other groups in the economy.
Furthermore, monetary policy plays a critical role in ensuring the stability of the financial system. The Fed provides liquidity to commercial banks by acting as the lender of last resort. When commercial banks face liquidity crisis, the Fed provides short-term liquidity. This can also be done by lowering capital requirements.
How Fed’s monetary policy contributed to the 2008/2009 financial crisis
The above section highlights the critical role the monetary policy plays in ensuring economic stability. This section highlights three ways in which the US monetary policy in the aftermath to the 2008-2009 financial contributed to the crisis.
Credit expansion policy
The financial crisis resulted from excess monetary supply fuelled by Fed’s loose monetary policy. Between 2003 and 2005, Fed had lowered its rate to unprecedented levels. The interest rate was kept at a rate lower than the appropriate level based on monetary policy guidelines as outlined by the Taylor rule. This started during the recession of 2001 when the Fed and other central banks expanded credit to boost economy recovery. The credit expansion by the Fed was aggressive under the chairmanship of Alan Greenspan. Money supply increased, and the M2 aggregate had increased by 10% by the year 2003. Economic theory provides that excess money supply in the economy increases the purchasing power of consumers thereby causing inflationary pressures.
When the recession began in 2001, the Fed funds rate was 6.5%, but it had gone down to 1.75% by the end of the year. By mid-2003, the interest rate had fallen to 1%, and it stayed at 1% for a year. This implies that the real interest rate was negative while its target inflation rate was 2%. This shows that the interest rate was below the Taylor Rule’s estimated rate required to keep the inflation rate at 2% (Brezina, 2012).
The demand bubble created was transferred to the housing market. Between 2003 and 2007, the dollar value of final goods and services sold grew at between 5 and 7% while that of real estate loans grew between 10 and 17% (Hemisphere Dept, 2011). There was an increase in the demand for mortgages and this further increased the demand for new housing.
Between 2001 and 2004, Fed cut its funds rate thereby lowering the interest rates on short loans. The interest rate on short loans was lower than that of long-term loans. This also affected the type of mortgages issued (Beckworth, 2012). Mortgage lenders introduced adjustable-rate mortgages that were at lower interest rates than the longer-term mortgages. The adjustable-rate mortgages were based on one-year interest rates hence, they were cheaper than 30-year mortgages (Hemisphere Dept, 2011). This caused a shift in the demand for adjustable-rate mortgages as the demand more than doubled between 2001 and 2004. The worst part was that many borrowers of adjustable-rate mortgages relied on the Fed to keep the interest rates low for a long time.
The loose monetary policy also provided excess liquidity to commercial and investment banks (Braude, 2013). Mortgage lenders were focused on maximising returns hence they lent to several low-income earners who were determined to own houses. The housing market was one of the drivers of the US economy hence most securities were mortgage-backed securities. The increase in subprime mortgages to underqualified borrowers was not just caused by the Fed’s loose monetary policy but also the decisions of the Congress and the federal government (Hetzel, 2012). The federal government had initiated programs to ensure affordable housing to even low-income earners. The government relaxed the down payment requirements on mortgages making them more affordable. In most cases, the down payment required on mortgages makes the mortgages unaffordable especially to the low-income earners. Nonprime mortgages usually required 20% down payment. The Federal Housing Administration also promoted the subprime mortgage crisis by strengthening the Community Reinvestment Act. When the Federal Housing Administration was formed in 1934, its mandate was to insure mortgage loans advanced by private firms. It required a down payment of 20% if the total mortgage value. However, it had reduced the down payment required to 3% by 2004. The government also pushed and subsidised Fannie Mae and Freddie Mac to enhance the provision of affordable mortgages to low-income earners. The Congress also pushed Fannie Mae and Freddie Mac to acquire more mortgages that are lent to low and moderate-income borrower. The new Community Reinvestment Act rules also forced some banks to form partnerships with community groups to distributing mortgages to millions of low-income earners.
Fed’s interest rate hike in 2005
On 12th December 2005, the Fed had raised its rate 4.25%. This was the 12th consecutive increase since June 2004. While increasing interest rate was required to move the economy to the neutral level, it had adverse effects. It resulted in higher rates for car loans, adjustable-rate mortgages and credit cards. This implied that home owners who acquired mortgages at lower rates had to pay higher rates since the mortgages were adjustable-rate mortgages. The demand for these mortgages declined and house prices peaked and began to fall. Mortgage refinancing and selling houses to finance the payment of mortgage interest and principal obligations became impossible. Several borrowers, especially low-income earners defaulted in paying their mortgage interests. There was a free-fall in the prices of houses hence house owners could not resell their houses to repay mortgages. Lenders and investors in subprime mortgages started making losses due to numerous defaults by borrowers (Eichengreen, 2014). Some of the lenders suffered substantial financial losses that they were unable to meet their obligations. This was worsened by the fact that some investors borrowed money to acquire mortgages then resold the mortgage to borrowers.
Things got worse in April 2007 when New Century Financial Corporation filed for bankruptcy (Eichengreen, 2014). The firm was the leading lender of subprime mortgages. This promoted the credit rating agencies to downgrade subprime mortgages. Besides, several mortgage-backed securities were downgraded to the high risk. Mortgage lenders stopped issuing subprime mortgages. Consequently, there was a reduction in the demand for houses since the demand was driven by the availability of sub-prime mortgages. Borrowers who were unable to repay their mortgages were in trouble as they could not sell their houses to repay the debt. The biggest casualties were the Fannie Mae and Freddie Mac. To prevent further losses, owners made it more difficult to qualify for mortgages, even to high and middle-income earners. This further led to the fall in house prices causing the collapse of the housing market.
The crash of the housing market affected the entire financial system since there were numerous mortgage-backed securities. Besides, the fall in the housing market led to a reduction in construction. The wealth in the economy also declined due to losses to individuals and financial institutions. The liquidity of lending institutions was also eroded thereby limiting their ability to lend to investors. Finally, the crash eroded investors’ confidence in securities thus making it difficult for firms to raise funds by issuing securities. This provided the stimulus for the 2008-2009 financial crisis.
The above two arguments demonstrate how the Fed’s monetary policy actions created a bubble in housing prices between 2001 and 2004 by lowering interest rates. The same Fed actions caused the bubble to burst when it raised interest rates between 2004 and 2006. It was ridiculous that Fed increased the rate more than twelve times in a span of just 18 months from June 2004 to December 2005. I believe a free-fall in housing prices could have been prevented had the interest rate cuts been gradual.
Misdiagnosis of the crisis
When the financial crisis started and became severe in August 2007, the Fed had the duty to use appropriate monetary policy actions to curb the crisis. However, the monetary policy actions it took were not effective in curbing the crisis. A proper policy action to deal with a financial crisis should be preceded by an accurate diagnosis of the crisis. The cause of the crises must be precisely determined to ensure appropriate policy actions. For instance, a financial crisis caused by a tight monetary policy could be solved by loosening monetary policy. Tight monetary policy actions are associated with lack of liquidity. As described in the previous section, the 2007 financial crises did not result from a liquidity crisis but mismanagement of risk by lenders.
The first intervention by the Fed came in December 2007 with the creation of Term Action Facility. The housing crisis led to an increase in money-market interest rates. The increase was primarily due to the increase in risk. The Term Action Facility was meant to reduce money-market interest rates thus reducing interest-rate spreads by providing liquidity (Rudebusch, 2016). The policy action failed to solve the crisis since it was based on a wrong diagnosis. It could have worked if the crisis was caused by lack of liquidity, which in this case, was not true.
The second and the third policy response actions were also not successful. In April 2008, the Fed lowered its federal target rate to 2% from 5.25% in August 2007 (Taylor, 2016). The reduction in the rate was aimed at reducing money market rates and enhancing liquidity in the financial markets. Since high interest rates were not the cause of the financial crisis, Fed’s response was futile. In fact, it was counterproductive. A reduction in interest rates caused a fall in the demand for US dollars since fewer investors were willing to invest capital in the US market due to lower returns. The fall in the demand for US dollars caused a sharp fall in the value of the dollar. The effect spilled into the oil market as oil prices increased. Within just four months, the price of oil had doubled, but the prices fell afterwards. The misdiagnosis of the financial crisis and inappropriate policy responses prolonged the financial crisis. After failing to combat the crisis, it worsened in September 2008. The economy experienced a severe credit crunch which spread to other countries.
Counterarguments on the cause of the 2008-2009 financial crisis
Proponents of the actions by the Fed during the crisis as well as other analysts have argued that the financial crisis was caused by other factors and not ineffective monetary policies. For instance, Ben Bernanke argues that excessive money supply and low interests rates were not responsible for the 2008-2009 financial crisis (IMF, 2009). He postulates that even the Fed’s action to lower the interest rate was appropriate. He further argues that non-monetary forces caused a fall in real interest rates hence it was necessary for the Fed to lower the nominal interest rate. According to Bernanke, imbalances between savings and investments globally caused a fall in global real interest rates which then put downward pressure on the nominal interest rate. This argument does not hold water. As much as non-monetary forces caused the real interest rate to fall, the Fed should have determined the impact of lowering the nominal interest rate before taking such actions. A lower interest rate increases money supply in the economy thereby causing demand-pull inflation. Increased money supply can cause a surge in the demand for securities thus creating a bubble (Mankiw, 2014). The bubble in the housing market was created as a result of excess money supply which was channelled to the housing market.
Other proponents also argue that the crisis was brought about by imbalances in the global economy. They argue that emerging countries like China had massive current account surpluses while developed countries like the US and UK large current account deficits. This caused significant capital inflows into the US thereby causing a fall in the US domestic interest rates. They further argue that the fall in interest rates and a fall in savings made investors in the UK and the US to engage in financial innovation to maximise returns. This led to complex securities that making it difficult to manage risks. I disagree with this argument. Differences in current account balances exist between countries, but that is not sufficient to cause a financial crisis of such magnitude. Besides, in free internal trade, arbitrage opportunities are eliminated with time. If capital inflows into the US caused a fall in interest rates, the fall could not continue to such dangerous levels. After some time, the arbitrage opportunities could have been eliminated thus preventing further increases in capital inflows.
Conclusion
The above analysis shows that the Fed’s monetary policy caused the 2008-2009 financial crisis. The expansionary monetary policy action by the Fed in response to the 2001 recession was overly. Besides, it lowered interest rate below the appropriate level and kept it low longer than enough. The excessive money supply was channelled to the housing market causing a surge in the demand for houses. Alongside other measures to promote affordability of mortgages by low-income earners, the monetary policy created a bubble in the housing market. When the prices of houses peaked and started falling, the bubble burst led to the collapse of mortgage lenders. Besides, the first policy responses to the crisis were inappropriate thus prolonging the crisis.
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