Fed Off the Hook for the Housing Bubble?

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The Federal Reserve might have had less to do with the formation of the U.S. housing bubble than its critics claim.

Or so says a new National Bureau of Economic Research working paper "Can Cheap Credit Explain The Housing Boom," by Edward Glaeser, Joshua Gottlieb and Joseph Gyourko.

In a nutshell, the paper's authors find that low Fed interest rates could only explain about a fifth of the 53% rise in U.S. real housing prices in the decade to 2006. The authors also fail to find clear evidence that changes in mortgage approvals or loan-to-value levels were at fault either. In other words, easy credit wasn't at fault.

That won't come as a surprise to the Fed, which has routinely exonerated itself from blame.

Critics have long argued that the then Fed Chairman Alan Greenspan's overly aggressive use of rate cuts to mitigate market problems, which climaxed with a "lower for longer" policy in the wake of the 2001 tech and telecom bust, created an environment in which sequential asset bubbles were bound to form. First it was equities, then it was property.

What's more, Fed funds rates were well below where they should have been during the peak of the housing boom, as determined by Taylor rule calculations. The Taylor rule calculates where official interest rates should be relative to the difference between target and actual inflation rates and between actual GDP growth and potential GDP growth.

So if the Fed and the banks weren't at fault, who was?

Yale professor Robert Shiller produced research in the midst of the housing bubble that showed home buyers were egregiously too optimistic about where house prices were heading. But that just raises another question, writes Glaeser, Gottlieb and Gyourko: why were buyers so irrationally exuberant?

They provide no answers. As for the Fed, Alan Greenspan and current Chairman Ben Bernanke have consistently blamed global imbalances, which is to say a not too subtly pointed finger in the direction of China. Not only did excess Asian savings drive down market interest rates but also created expectations of permanently low interest rates.

What no one argues, however, is the Fed's role in creating an environment of moral hazard. Any and all corrections under Mr. Greenspan's tenure were met with enormous supplies of central bank liquidity. Wall Street was always and continually bailed out. This feeling of the giant asset safety net undoubtedly filtered through to Main Street as well. Mistakenly as it seems, since only the bankers routinely get off scot free.

The Fed is undoubtedly more culpable than the reports authors argue. Perhaps future papers will investigate the central bank's role in the culture of risk.

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