The ABCs of the Financial Meltdown — Arnold Kling

Here’s the short version.  Here’s the long version (pdf).  This is insightful and helpful work.  I recommend it to your attention.

The one thing Kling does not much explain is the role of Federal Reserve interest rate policy, or why he downgrades the significance of the Feds unprecedented low interest rate policies of the early and mid 2000s.  In the comments section of Kling’s blog, David Beckworth puts a light on the question:

I know you [Arnold] discuss the Fed’s low interest rates in the early-to-mid 2000s as a contributor to this crisis, but it seems to get little coverage there. I think it plays a more important role — though not the only one — than you let on.

First, by lowering interest rates the Fed created problems for fixed income managers: they were not getting they returns they needed. There was this popular phrase “the search for yield” back then that described their attempts to find yields in places they normally may not have gone (eg. CDOs).

Second, by lowering rates for to historically low levels and for a prolonged period the Fed encouraged substitution out of conventional mortgages into exotic ones with low introductory teaser rates. (See Lawrence H. White on this point.) Thus, it wasn’t just financial innovation but a distorted price signal (i.e. inordinately low rates) created by the Fed that encouraged home buyers to try new types of mortgages.

Third, given that many emerging markets peg their currency to the dollar the Fed’s monetary policy got exported across the globe at this time. Even the ECB and the BoJ had to be mindful less their currencies lost export competitiveness and thus they loosely followed the Fed. The Fed’s policies then helped create a global liquidity glut that fueled a global housing boom. Some of those funds got recycled back to the United States See here for more.

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