Bernanke Spreads the Blame

During his appearance before the Congressional Joint Economic Committee earlier this week, Federal Reserve Chairman Ben Bernanke said that there is plenty of blame to go around for the financial crisis that is wreaking havoc on global markets. He identified the collapse in housing prices as the root of the crisis, since this collapse effectively erased trillions of dollars' worth of value in mortgage-backed securities held by Wall Street institutions. This explanation, while partially correct, ignores the more fundamental basis of the crisis, which was the practices that led to an unsustainable housing bubble in the first place.

As housing prices continued to rise in the early-to-mid 2000s, lending institutions came to believe that the risk of lending to homebuyers was mitigated by the continually-rising value of houses. That is to say, they came to believe that the risk of default on these loans was minimized because a home could always be sold for more than the value of the mortgage.

In this environment, two dangerous things happened. First, credit institutions began giving out riskier mortgage loans, often without proof that the debtor was able to pay for the mortgage. Second, the risk associated with these loans was further disguised by trading in subprime (riskier) mortgage-backed securities. These securities -- essentially bundles of subprime mortgages -- were internationally traded by the original loaning banks, passing on the risk associated with the loan to others. This system created a moral hazard in which no one felt that they were assuming the risk of lending or borrowing. The problem was further exacerbated by the extreme difficulty of ascertaining the true value of these mortgage-backed securities.

There is no doubt that these events represent a massive failure in the market, but this is not the whole story. What is not being discussed is the role of the Federal Reserve in causing the housing bubble. Federal Reserve and Treasury Department officials are pointing fingers wildly -- at short sellers, mark to market practices, and countless other incidental factors in the crisis. The truth is that, coming out of the "dot-com" collapse, the Greenspan Fed's irresponsible policies held interest rates artificially low when the market needed higher, corrective rates. The cheap credit that this foolish policy created allowed the initial malinvestments that then exploded into the housing bubble.

Federal Reserve policies held down the price of borrowing money in a time when, according to basic economic principles, borrowing should have been more costly as a result of the dot-com bust. Seeing a deal, borrowers exploited this cheap credit by taking on huge amounts of debt in a way that ultimately proved unsustainable. Had interest rates more closely approximated natural market rates, there would have been no cheap credit that fueled the housing bubble. With no housing bubble, the moral hazards that further fueled the bubble would not have arisen, and there would have been no subsequent crash.

When Bernanke says that the housing crash is the cause of this crisis, he is telling the truth, but only a small part of the truth. As long as the Federal Reserve is allowed to arbitrarily set interest rates, manipulate market tendencies, and create credit out of thin air through irresponsible money printing, we will continue to see unnatural booms and catastrophic busts.

Any attempt to fix our faltering economy must be based on an honest assessment of how things got so bad in the first place. Bernanke will no doubt continue to point fingers at everyone but those responsible, but it is our responsibility to tell the troubling truth -- that the biggest finger should point squarely at those now entrusted to save our economy.