Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?

Would a Stricter Fed Policy and Financial Regulation Have Averted the Financial Crisis?, by Jagadeesh Gokhale and Peter Van Doren
Cato, October 8, 2009

Many commentators have argued that if the Federal Reserve had followed a stricter monetary policy earlier this decade when the housing bubble was forming, and if Congress had not deregulated banking but had imposed tighter financial standards, the housing boom and bust—and the subsequent financial crisis and recession—would have been averted. In this paper, we investigate those claims and dispute them. We are skeptical that economists can detect bubbles in real time through technical means with any degree of unanimity. Even if they could, we doubt the Fed would have altered its policy in the early 21st century, and we suspect that political leaders would have exerted considerable pressure to maintain that policy. Concerning regulation, we find that the banking reform of the late 1990s had little effect on the housing boom and bust, and that the many reform ideas currently proposed would have done little or nothing to avert the crisis.

Commentators have also argued that the popularization of financial products such as teaser-rate hybrid loans for subprime homebuyers and credit default swaps for investors is to blame for the financial crisis. We find little evidence for this. Housing data indicate that the majority of subprime hybrid loans that have entered default had not undergone interest rate resets, and the default rate for subprime hybrid loans is not much higher than for subprime fixed rate loans. Concerning swaps, although their introduction may increase financial inflows into risky sectors, their execution through a clearing-house or regulation via other means would not necessarily have avoided the mispricing of risks in underlying contracts. Capital requirements for the credit default swaps that were used to insure mortgage-backed securities would have been low because housing investments were not considered risky.

Full text: http://www.cato.org/pubs/pas/pa648.pdf

Jagadeesh Gokhale is a senior fellow at the Cato Institute and the author of Social Security: A Fresh Look at Reform Alternatives (forthcoming). Peter Van Doren is a senior fellow at the Cato Institute and the editor of Cato's Regulation magazine.