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Even a free market cheerleader like the late Milton Friedman acknowledged that the government should take a role in setting monetary conditions. A new working paper published by the U.S. Federal Reserve, however, finds in its preliminary research that not all interventions are created equal. The report observes that, while some instances of regulatory credit tightening have reduced consumer debt growth, loosening of credit conditions appears to be much less effective as a policy tool. Canadian Finance Minister Jim Flaherty will be pleased to hear that; Fed chairman Ben Bernanke, not so much.
You'd be hard pressed to find anyone who supports former Fed chairman Alan Greenspan's actions leading up to the financial crisis. His laissez-faire monteary policy is now widely blamed for the forming of the subprime housing bubble, which the authors of the study – Douglas J. Elliott of the Brookings Institution, Greg Feldberg of the Office of Financial Research and the Fed's Andreas Lehnert – identify as the moment when the consensus among economists shifted towards intervention. But over the last 100 years, intervention was hardly rare. The authors cite dozens of instances where government prodded, pressured or forced outright various cyclical aspects of borrowing and/or lending, from war-time general credit controls to very specific guidelines promoting some types of credit (small business loans) and discouraging others (commodity speculation) during the crises of the late 1970s and early 1980s. In retrospect, Mr. Greenspan's tenure was the exception.
Efforts to constrain credit during overheating markets were often met with howls of derision, something Mr. Flaherty will recognize. The following passage reads like real estate industry's reaction to his move in 2012 to cut amortizations on CMHC-insured mortgages to a maximum of 25 years: "Industry participants said that, by restricting access to credit, they discriminated against low-income borrowers and others with limited options for raising cash." In fact, the passage describes a statement by the American Bankers Association in 1951, responding to loan-to-value limits, maturity caps and other underwriting regulations that had been implemented after World War II.
Happily for Mr. Flaherty, though perhaps not for Canadian first-time home buyers, the Fed paper notes approvingly that "terms associated with a tightening of [underwriting standards] induced households to borrow less, either because the terms made debt less attractive or because marginal borrowers were completely rationed out of the market."
The authors also note, however, that "credit apparently responds asymmetrically to macroprudential tightening and easing, with tightening followed by a significant decrease in credit but easing followed by, at best, a small and insignificant increase in credit." Take the example of the interest rate ceilings imposed on savings accounts in the late 1960s – similar in spirit if not in mechanism to Quantitative Easing, in that such moves were intended to prod savers and banks to seek returns elsewhere, like in housing loans. According to the Fed paper, it didn't work; large banks moved into other non-deposit sources of funds, while smaller ones simply curtailed activity.
Perhaps motivated by Reinhart and Rogoff-gate, the authors of the paper take pains to point out that their statistical findings are preliminary, so don't bet on Mr. Bernanke giving up on his open market operations based purely on this text. Still, those investors hoping QE will evenutally push the gun-shy out of cash and bonds and back into equities should rethink their strategy. Unless, of course, this time turns out to be different.
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