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Many commentators have argued that if theFederal Reserve had followed a stricter monetary policy earlier this decade when the housing bub-ble was forming, and if Congress had not deregu-lated banking but had imposed tighter financialstandards, the housing boom and bust—and thesubsequent financial crisis and recession—wouldhave been averted. In this paper, we investigatethose claims and dispute them. We are skepticalthat economists can detect bubbles in real timethrough technical means with any degree of una-nimity. Even if they could, we doubt the Fedwould have altered its policy in the early 21st cen-tury, and we suspect that political leaders wouldhave exerted considerable pressure to maintainthat policy. Concerning regulation, we find thatthe banking reform of the late 1990s had littleeffect on the housing boom and bust, and that themany reform ideas currently proposed would havedone little or nothing to avert the crisis.Commentators have also argued that thepopularization of financial products such asteaser-rate hybrid loans for subprime homebuy-ers and credit default swaps for investors is toblame for the financial crisis. We find little evi-dence for this. Housing data indicate that themajority of subprime hybrid loans that haveentered default had not undergone interest rateresets, and the default rate for subprime hybridloans is not much higher than for subprimefixed rate loans. Concerning swaps, althoughtheir introduction may increase financial inflowsinto risky sectors, their execution through a clearing-house or regulation via other meanswould not necessarily have avoided the mispric-ing of risks in underlying contracts. Capital re-quirements for the credit default swaps that wereused to insure mortgage-backed securities wouldhave been low because housing investments werenot considered risky.
Would a Stricter Fed Policy and Financial  Regulation Have Averted the Financial Crisis? 
by Jagadeesh Gokhale and Peter Van Doren
_____________________________________________________________________________________________________
 Jagadeesh Gokhale is a senior fellow at the Cato Institute and the author of 
Social Security: A Fresh Look atReform Alternatives
(forthcoming). Peter Van Doren is a senior fellow at the Cato Institute and the editor of Cato’s
Regulation
magazine.
Executive Summary 
No. 648October 8, 2009
 
Introduction
Many commentators argue that the hous-ing market boom and bust, the subsequentimplosion of financial markets, and the reces-sion that followed have two important causes:inappropriately loose monetary policy during2003–2005 and financial market deregulation,including the 1999 Gramm-Leach-Bliley bank-ing reform act (GLB), the lack of regulation of credit default swaps, and loose capital and lever-age standards.
1
The commentators claim thattighter Federal Reserve Policy and stricter capi-tal market regulation would have averted thecrisis and should be adopted now to avoidfuture crises.We investigate these claims and disputethem. First, economists cannot detect asset-price bubbles in real time through technicalmeans with any degree of unanimity. Second,even if economists could detect asset-pricebubbles without significant controversy, theFed may not have enacted tighter monetary policy in the period prior to the housing bub-ble because of heightened concerns aboutdeflation at the time. And if the Fed had adopt-ed such policy, it would have faced severe bipar-tisan criticism from Congress and the WhiteHouse, which wanted low interest rates at a time when inflation was low and economicgrowth was sluggish following the 2001 reces-sion. Third, even if bubble detection were pos-sible and the Fed had political support to stopbubbles, it could not have used its short-termrate-setting power to stop housing bubblesduring the 2004–2006 period because Fedshort-term rates were no longer correlated withshort- or long-term mortgage interest rates.Our discussion of financial market dereg-ulation includes discussion of three claims.The passage of Gramm-Leach-Bliley Act hadthe accidental effect of lowering the capitalstandards governing investment banks, but itdid not mean the banks were operatingunder laissez faire. Instead, they were subjectto the Basel I and II regulatory framework,which considered investment in residentialmortgages to be fairly safe.Second, we consider credit default swaps(CDSs), and argue that, although their intro-duction may increase financial inflows intorisky sectors, their execution through a clear-ing-house or regulation via other means wouldnot necessarily have avoided the mispricing of risks in underlying contracts. Capital require-ments for CDSs that insured mortgage-backedsecurities would have been low because hous-ing investments were not considered risky.Third, many have argued that low teaser-rate hybrid loans and low capital standardsfor financial institutions are to blame.
2
 Yet,the data do not support the teaser-rate argu-ment because the majority of mortgages inforeclosure had not undergone interest rateresets, and increased capital standards wouldlikely have led to increased risk taking asfinancial firms pursued what appeared to besafe but high returns in the residential realestate market.In short, the many policy proposals thatadvocates on the Left and Right now say arenecessary because of the financial crisis—suchas stricter regulation of derivatives and bank-ing, higher reserve requirements, and moreconservative Fed policy—would have done lit-tle to avert the financial crisis. The crisis issimply the product of the widespread belief that residential real estate investment is “safeas houses,” and it is unclear what policy couldhave disabused both policymakers and finan-cial markets of a firmly held, but false, belief.
Detecting the Home PriceBubble—A Failure?
Many argue that an essential componentof any policy to prevent future financial crisesand their negative effects on the real econo-my is the detection of asset-price bubbles.
3
For such a policy to be successful, economistsmust be able to use the technical tools of thediscipline to distinguish sustainable fromunsustainable asset appreciation in real timeand inform decisionmakers about appropri-ate policy responses. We believe that the trackrecord of forecasts during the recent hous-
2
Economistscannot detectasset-pricebubbles in realtime throughtechnical meanswith any degreeof uniformity.
 
ing-price bubble suggests that such a faith inthe ability of technical analysis to reveal “thecorrect” answer is unwarranted. As housingappreciation occurred from 2000 to 2006,consider the quotations that follow fromsome prominent economists who doubtedthat there was a housing bubble or who be-lieved that the bubble posed little risk to thebroader economy.Suzanne Stewart and Ike Brannon, congres-sional staff economists, wrote in the spring of 2006:Predictions about home prices have gonefrom a sober questioning of future pricegrowth to shrill apocalyptic predictionsof an impending market collapse thatwill trigger a deep recession. . . . With nospecter of inflation . . . relatively low returns . . . and a stagnant stock market. . . who is to say that . . . a family spend-ing another $100,000 on a nicer house isnot making a wise decision?
4
Robert Van Order and Rose Neng Lai, profes-sors at the University of Michigan’s BusinessSchool and University of Macau, China, respec-tively, conducted statistical tests of momen-tum shifts in home price increases. They con-cluded in November of 2006:We find evidence of momentumthroughout the period (1980 and later)and some evidence that the momen-tum increased after 1999, but not by a lot. We find no evidence of an increasein volatility. We also do not find evi-dence of explosive momentum after1999, nor do we find much differencein price growth behavior between thebubble and nonbubble candidate cities.We do find that momentum operateswith a long lag. There were always bub-bles, but not large regime shifts, at leastnot in our sample period.
5
Writing in the Federal Reserve Bank of New  York’s
 Economic Policy Review
in December2004, bank senior economist JonathanMcCartney and vice president Richard W.Peach said:Home prices have been rising strongly . . . prompting concerns that a bubbleexists . . . and that home prices are vul-nerable to a collapse. . . . A close analy-sis of the U.S. housing market . . . findslittle basis for such concerns. The . . .upturn in home prices is . . . attribut-able to strong market fundamentals. . . and regional price declines in thepast have not had devastating effectson the broader economy.
6
 John V. Duca, vice president and senior econ-omist at the Dallas Federal Reserve, wrote inthat bank’s
Southwest Economy
in spring of 2004:Overall home prices have risen . . . by 37percent since 1997 (26 percent whenadjusted for inflation). Such increaseshave raised concerns that low interestrates have spawned a housing-pricebubble. . . . One key finding is thatalthough there is little risk of a nation-al bubble, prices in some areas are vul-nerable if local economic conditionsdeteriorate.
7
One year later, he wrote in the same journal:Mortgage innovations have made hous-ing a more liquid, and thus more attrac-tive, asset. In addition, the demand forowning more than one home has recent-ly increased. For these reasons, pricesmay not be as overvalued as [a chart inthe journal] suggests.
8
 Alan Greenspan, then chairman of the FederalReserve, told a congressional committee in June 2005: Although we certainly cannot rule outhome price declines, especially in somelocal markets, these declines, were they to occur, likely would not have sub-
3
The majority of mortgages inforeclosure hadnot undergoneinterest rateresets.
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