Low interest rates weren’t to blame for the housing bubble

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That was one of the themes of Ben Bernanke’s speech to the American Economic Association yesterday. And this is the nifty chart he used to make his case:

Change in house prices is plotted on the vertical axis, so countries with bigger bubbles appear closer to the top of the chart. Right off the bat, that’s pretty interesting—the U.S. run-up was by no means the most drastic.

The horizontal axis shows average Taylor rule residuals. The what now? The Taylor rule is a way of predicting what the overnight federal funds rate should be. For our purposes, what’s important is how much monetary policy in each country deviated from that prediction. The further left you go on the chart, the looser policy was from 2002 through most of 2006. By that measure, the U.S. had some of the easiest money in the developed world—hence the criticism that low interest rates stoked the housing bubble.

But that’s not the conclusion you’d draw from this chart. As Bernanke pointed out yesterday, 11 of the 20 countries studied saw bigger housing bubbles than the U.S. while also having tighter monetary policy. The overall relationship between house prices and monetary policy, as expressed by that gray line, is as one would expect. The line’s downward slope shows that tighter monetary policy goes with lower house-price appreciation—but the result is very slight and actually isn’t statistically significant. Differences in monetary policy only explain 5% of the variability in house-price appreciation across countries.

What did cause the housing bubble then? Bernanke’s theory—which we’ve heard before—has to do with money flowing from emerging markets into industrialized countries, the so-called global savings glut hypothesis. He had another slide showing a strong relationship between capital inflows and house-price appreciation for the same set of nations. That relationship explained about 31% of the variability in house-price appreciation across countries.

Bernanke’s broader conclusion, the one that made headlines, is that what we need going forward is “better and smarter” regulation, not a Federal Reserve that uses interest-rate hikes to quash asset bubbles. When money was flowing into the U.S., letting every Tom, Dick and Harry borrow cash to buy a house, the response shouldn’t have been to up interest rates, but rather to crack down harder on new mortgage products and slipping underwriting standards. Bernanke isn’t ruling out monetary policy as a supplementary tool in addressing financial risk, but based on evidence from our last go-around, he just doesn’t see it as having the greater shot of success.


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