• Eric Englund writes in April 22nd 2006 the article “The Federal Reserve and Housing: A Cluster of Errors?” warning about the link between interest rates and housing prices:
  

  The hyperreality conjured by the Federal Reserve’s relentless inflation of the money supply is characterized by a populace which believes that a permanent plateau of prosperity has been attained. This is the boom phase of the trade cycle. [...] When the bust phase of the trade cycle materializes [...] then the real horror show will unfold. Let’s face it: highly leveraged Americans have little to no chance of ever paying back their enormous mortgage debts. [...]

  The Federal Reserve “engineered” America’s housing bubble. [...] [I] quote from page 1 of a September 2005 study sponsored by the Board of Governors of the Federal Reserve System titled House Prices and Monetary Policy: A Cross-Country Study [...]: “Like other asset prices, house prices are influenced by interest rates, and in some countries, the housing market is a key channel of monetary policy transmission.”

  With the bursting of the NASDAQ bubble signaling that the U.S. was heading into a recession – not to mention the shock of 9/11 – the Federal Reserve took desperate measures by goosing the money supply and driving the Fed Funds rate down to 1%. These monetary central planners knew that housing demand was very much interest rate sensitive, and they were counting upon the opiate of easy credit, at remarkably low interest rates, to stimulate the “animal spirits” of Americans in order to set the housing market ablaze.

• Robert P. Murphy writes an article on April 4th 2008 stating that the Fed’s role in the housing bubble is a classic illustration of the Austrian business cycle theory of the economy:
  

  [The] Figure [on the right] seems to be the textbook illustration of how the Federal Reserve conducts its open market operations: When it cuts the federal funds target rate, it pumps reserves into the system, i.e., expands the monetary base. On the other hand, when the Fed raises interest rates, it slows the rate of monetary expansion. Except for the large blips due to the Y2K scare — when the Fed flooded the system with liquidity and then sucked it right back out — the early 2000s fit the pattern perfectly. That is, when Greenspan cut the target rate from January 2001 through June 2003, the monetary base grew rapidly. Eventually the base growth came back down to moderate territory, but that was when the Fed was ratcheting up interest rates, just as we would expect.

  Image from Mises.org

• Ben Bernanke is quoted in an article in the Washington Post on October 27th 2005 written by Nell Henderson to doubt that the housing bubble burst:
  

  Ben S. Bernanke does not think the national housing boom is a bubble that is about to burst, he indicated to Congress last week, just a few days before President Bush nominated him to become the next chairman of the Federal Reserve.

  U.S. house prices have risen by nearly 25 percent over the past two years, noted Bernanke, currently chairman of the president’s Council of Economic Advisers, in testimony to Congress’s Joint Economic Committee. But these increases, he said, “largely reflect strong economic fundamentals,” such as strong growth in jobs, incomes and the number of new households.

  “House prices are unlikely to continue rising at current rates,” said Bernanke, who served on the Fed board from 2002 until June. However, he added, “a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year.”

• When the Housing Bubble burst, Alan Greenspan on 8th of April 2008 in an interview on CNBC defends the role of the Fed in the housing bubble:
  

  More than two dozen economies have had housing bubbles and all are related to the dramatic decline in real long-term interest rate that occured from the 1990ies onwards. [...] You can fully explain the bubble by what is going on globally.

  A paper by Christian Upper and Andreas Worms from the Deutsche Bundesbank explains the connection between monetary policy and long-term interest rates.

  Two blog-posts (from 2005) discussing Greenspans views on the Long-Term-Interest-Rates are “Greenspan on interest rate mystery and the “Long-Term-Interest Rate Mystery” by Kash Mansori.

• Jeffrey Rogers Hummel and David R. Henderson write that they “Blame Federal Gov’t, Not The Fed, For Subprime Mortgage Problems“:
  

  The better way to judge monetary policy is by the monetary measures: MZM, M2, M1 and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20% to nearly 0% by 2006. During that time, M2 growth fell from over 10% to around 2%, and M1 growth fell from over 10% to negative rates. [...] Monetary policy was not expansionary.

  First, the federal government contributes to what economists call moral hazard. [...] [P]eople who buy their repackaged loans [...] assume an implicit federal government guarantee. [...]

  The second way the feds contributed to the subprime mess was with a little-noted change in regulations by the comptroller of the currency in December 2005 that acted as the trigger. [...] The comptroller started requiring banks to require minimum payments on credit card balances, causing increases of at least 50% for most cards and as much as 100% on others. Many people who hold subprime mortgages are people for whom a higher monthly payment on a credit card would be a problem. [...] With the new regulation, you instead make your credit card payment but miss your mortgage payment, a widely observed transformation in the traditional American delinquency pattern. [...]

  The third federal contributor to the subprime crisis is the Community Reinvestment Act. This act, first passed in 1977 and beefed up in 1995, requires banks to lend to high-risk areas that they otherwise would avoid. Those banks that fail to comply pay fines and have more difficulty getting approval for mergers and branch expansions.

• Unfortunately, there is not enough time to go deeper into the debate, but it should be pointed to these links: Greenspans Article in the FT from March 18th 2008 “We will never have a perfect model of risk”, criticism and his response.

(This skepticism edges on the border of radicalism, for instance when he assaults the environmentalist movement and compares them to communism and nazism, without understanding the political economy governing global environmental regimes.)

In his article, he calls for a return to the Gold Standard. The standard argument against a return to the Gold Standard is that the volume of gold does not grow fast enough as the volume of money that is needed for the economy to grow. To fix that problem, Reisman proposes to set the price of Gold held at the reserve at about 12.700 US-Dollars and then assign this gold to the banks holding deposit accounts and other type of highly liquid assets.

Unfortunately, he does not discuss one prominent problem with the Gold Standards: most of the US-Dollar-Reserves are not held by commercial banks inside the USA, but by Central Banks outside the USA. Would the Fed really hand over their gold (even if it stays in their vault) to the Chinese Central Bank, for instance?

Reisman also discusses the vicious circles of highly-leveraged financial markets and how deflation can spread through an economic system. What is particular interesting are how the losses occured from loans in subprime mortgage market can have a more detrimental effect on the economy as whole (his full argument is present in the CMAP, click on the picture).

First, from bond-insurers to credit-rating-agencies to banks:

[B]anks’ capital now hinge[s] on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms [...] reduce the ratings of all the bond issues [...] deprived of insurance coverage. [...] [L]ower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. [If these] bonds were owned by banks, the value of the banks’ assets would be correspondingly reduced [...]

Secondly, from banks to prime-mortgage-lenders:

As the result of losses sustained in subprime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets.

Thirdly, from the prime-mortgage-lending market to government-sponsored lending market:

The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. [...] The Federal Reserve’s rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages.

Fourthly, from banks to the business needing credit:

The decline in the assets and capital of banks [...] reduce[s] the ability of banks to lend money to borrowers to whom they would otherwise normally lend. The effects of such credit contraction [...] be seen in the growing difficulty even of sound firms to obtain financing required for expansion.

Fifthly, from the banks credit contraction to a multiple credit contract because of minimum capital requirements:

[R]eductions in the capital of banks can result in multiple contractions of credit. [...] [B]anks are normally required to possess capital equal to five percent of their outstanding loans and investments. [...] [R]eductions in banks’ capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.

Sixthly, from multiple credit contraction to reduction of money supply

Credit contraction by banks [is 9reducing the outstanding volume of checking deposits in the economic system and [...] the quantity of money in the economic system. [...] If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears.

Seventhly, from money supply to business earnings to business spending to wages to private consumption:

Such contraction of credit and money operates to reduce the amount of spending in the economic system. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues. This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers’ goods.

Eightly, from decreased spending of businesses and consumers to banks:

As the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.

The message is clear: a small loss in a small share of the market can result in a contraction of the whole economy through various feedback loops.