Blame the Fed

In a recent WSJ editorial, Rep. Ron Paul blames the Fed for the Financial Crisis. Apparently, the Fed “. . . fails to see that the price of housing was artificially inflated through the Fed’s monetary pumping during the early 2000s . . .” {WSJ, Oct. 20, 2011, p. A17}. Elsewhere in the editorial he writes that “Adding new money increases the supply of money, making the price of money over time – the interest rate – lower than the market would make it.”

Let’s consider this Part II of our explanation of the Great Recession. Apparently, Representative Paul distills his wisdom from Hayek and Mises. Nevertheless, his rendition of how money works is a pretty good representation of the Keynesian effect. If money increases more rapidly, then the interest rate falls. I don’t want to discourage this view, but it is a limited view.  Another view is: If the money supply increases more rapidly, there may be an inflation. Inflation causes the interest rate to rise . . . not fall. This is the Fisher effect.

Prior to 2006, the money supply was, in fact, increasing at a modest but steady rate. I’m referring to M1, the least complex measure of the money supply. The facts do not support Rep. Paul’s view. At the beginning of 2006, the rate of increase in the money supply changed dramatically. At this point, the money supply stopped growing. That is, there is a kink in the data. A small growth rate prior to 2006 and no growth after 2006 (and before the Great Recession). So the facts profoundly do not support Rep. Paul’s view.

Why, you may wonder, did the money supply stop growing in 2006? Well, we had new management at the Fed. Chairman Bernanke came in. One could speculate that he may have felt that the economy was overheating and he should apply the brakes, but this would just be speculation. From my experience, it is useless to depend upon the public relations statements that come from the Fed for a sense of their intent. The bottom line is that the posture of monetary policy from the beginning of 2006 was contractionary. This is one of the factors that contributed to the Great Recession.

The Great Recession began to hit in 2007. The first symptom was that housing prices began to dip and this set off a wave of foreclosures. It did so because the housing finance sector had become extremely delicate due to the high loan to value ratios facilitated by government programs. All it took was a slight dip in prices to cause values to fall below the balance due on many mortgages. This is what set off the defaults and foreclosures.

So should we blame the Fed? Yes, in part, but for the exact opposite reason proposed by Rep. Paul.