The Role of Policy during the Housing Boom

  • Daniel Aronoff


It is the consensus opinion that monetary policy and banking regulation contributed to the boom. The charge lodged against the Fed is that it held the Fed funds rate too low for too long; that its loose monetary policy exacerbated the credit boom. There is a simple answer to this charge. The Fed had no choice but to do so. Its mandate from Congress required it to support employment to the maximum extent possible, subject to maintaining price stability. In the early 2000s, after the dot-com boom had ended, the current account deficit began to grow rapidly, which caused the hole in demand to expand and created deflationary pressure. The recovery from the 2001 recession was slow and tepid. It was dubbed a “jobless” recovery at the time. As late as 2004 Ben Bernanke, then a member of the Fed’s board of governors (but not yet it chairman), posed the question:

Two-and-a-half years into the economic recovery, the pace of job creation in the United States has been distressingly slow. Job losses in manufacturing have been particularly deep, with employment in that sector apparently only now beginning to stabilize after falling by almost 3 million jobs since 2000. Why has the recovery been largely jobless thus far?1

The fundamental problem faced by the Fed (whether or not the members of its policymaking Open Market Committee recognized it at the time) was that the large current account deficit presented it with a Faustian bargain; either to induce a deflationary monetary contraction in order to enable the US economy to adjust the terms of trade with China and reduce the trade deficit (since lower prices US goods would be more competitive on world markets), or to acquiesce in the expansion caused by the capital flow bonanza, albeit at the cost of accommodating a potentially destabilizing credit boom.2


Monetary Policy Financial Crisis Current Account Deficit Bank Reserve Broad Money 
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  1. 1.
    Ben Bernanke, “Trade and Jobs,” Federal Reserve Board, 2004. While Bernanke maintained that the current account deficit could not have been the cause of slow job growth, he may have been misled in similar way that subprime investors were misled. He looked at past correlations between trade and jobs and saw none. But the size of the US current account deficit was just then reaching unprecedented heights, which might have produced effects that were different than in the past. By 2005, when he delivered his “global savings glut” speech, Bernanke had begun to see the current account deficit as an important factor in US economic performance.Google Scholar
  2. 3.
    J. M. Keynes, A Treatise on Money, Vol. I, The Pure Theory of Money (Harcourt Brace and Company, 1930), p. 349.Google Scholar
  3. 4.
    Two giants of postwar monetary economics, Milton Friedman and Robert Mundell, who differed on almost everything, agreed on this point, though they attributed different causes of the 1930’s deflation. Freidman thought it arose from Fed’s failure to provide liquidity to banks when they faced depositor runs; Mundell argued that it was caused by the Fed’s sterilization of gold inflows. For Friedman’s argument, see Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States 1867–1960 (Princeton University Press, 1963), Chapter 7. For Mundell’s point of view, see his Nobel Prize lecture, available at However, it should be noted that Schularick and Taylor’s statistical analysis of the influence of credit and money suggests it was actually the contraction in credit, which was then highly correlated with money, that marked the Great Depression This interpretation is consistent with the analyses of the Great Depression made by Irving Fisher and Ben Bernanke that I reference in explaining the causes of the financial crisis later on in this book. Economist Claudio Borio and his colleagues at the Bank for International Settlements have produced evidence that questions whether deflation in wages and goods prices cause contraction in real output. Yet, the monetary policy implication is the same, whether it is a contraction in wages and goods prices or credit that is to be avoided. In both instances the mandate would be to keep interest rates low. See Claudio Borio et al., “The Costs of Deflations: A Historical Perspective,” BIS Quarterly Review (March 2015): 31–54.Google Scholar

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  • Daniel Aronoff

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