How to Prevent the Next Financial Crisis

What caused the financial crisis and Great Recession? A decade later, economists still don’t have a good answer. Of course, the financial bubble in the housing market was the proximate cause, but this begs the question of what inflated the bubble that burst in the first place.

This isn’t just an academic exercise for the history books. It’s critical that we never repeat the mistakes that liquidated more than $7 trillion of wealth and sent unemployment rates to their highest levels in three decades.

The real estate bubble was certainly exacerbated by half-witted national housing policies that offered low-down-payment mortgages with near 100 percent taxpayer guarantees to non-credit-worthy borrowers. The government made it easy for families to buy homes they couldn’t afford. And when the defaults rolled in, the taxpayers picked up the tab. But the role of low interest rates and inflationary monetary policy is underappreciated.

My colleague Louis Woodhill has crunched the numbers here. Woodhill finds that from October 2001 to July 2006, the Fed inflated and inflated with artificially low interest rates. The CRB commodity price index, which includes everything from aluminum to zinc, nearly doubled (up 84 percent). Oil prices more than doubled, to almost $75 a barrel.

These rising prices encouraged Americans to invest in inflation hedges — like houses. The Case-Shiller 20-Cities Home Price index rose in tandem with commodities, both peaking in July 2006. Then the Fed finally noticed the inflation and violently reversed course by raising interest rates, pushing the CRB index down by 14 percent in just six months.

This popped the housing bubble for sure, but there was no soft landing. The Fed’s shift from inflation to deflation inadvertently crushed the mortgage-backed securities markets. This made the recession that began in December 2007 inevitable. Then, a second course-reversal by the Fed in June 2008 created a severe scarcity of dollars that contributed to the collapse of the real economy.

If the Fed had been watching commodity prices and had held them stable, as Woodhill and I recommend in a recent Wall Street Journal article, these wild gyrations in prices would have been avoided. A housing correction might still have happened, but the economic carnage would have been limited.

In a March 27 article in The Wall Street Journal, economics columnist Greg Ip argued that critics of Federal Reserve Chairman Jerome Powell — like Woodhill and I — are wrong to recommend that the Fed keep prices for commodities stable.

Ip asserts that if the Fed had been targeting commodity prices in the 2000s, this would have made the recession worse by “tightening monetary policy in 2008 as the U.S. slid into its worst recession since the 1930s.”

Ip doesn’t get it. The financial bubble (which, by the way, the WSJ editorial page, where I worked, accurately warned of at the time) would have never been allowed to so severely overinflate if the commodity index had been held stable all along. The Fed would never have gotten itself into a position where it had to finance $1 trillion in bailouts.

The two-decade growth boom from 1983-2000 was characterized by relatively stable commodity prices. Economists now call this period “The Great Moderation,” because growth was high and prices flat. That is what the Fed should be attentive to today. Other prices (e.g., consumer, producer and asset prices) should also be closely monitored, but stable prices and a stable economy require stable commodities. When it comes to inflation, commodity prices are the canary in the coal mine because this information is available to policymakers in real time.

If the Fed targets stable prices on top of the pro-growth tax, regulatory and energy policies the Trump administration has implemented, 3 to 4 percent real growth with continued rising wages for workers and low inflation is easily achievable over the next several years at least.

The Patriot Post® · How to Prevent the Next Financial Crisis