How the Fed Ended Up Fueling a Subprime Boom

Bernanke Greenspan FOMC subprime low interest rates

Bernanke Greenspan FOMC subprime low interest rates

Plenty of writers have claimed that the Fed fueled the sub-prime boom by holding interest rates too low for too long after the dot-com crash.   But hardly anyone has tried to explain why it did so.

Yours truly has taken a stab at it, together with his former student (and now eminent Market Monetarist) David Beckworth, and former UGA colleague (and current Özyeğin University faculty member) Berrak Bahadir, in this just-published article in the Journal of Policy Modeling.

Our argument, in brief, is that the Fed blew it by treating the exceptionally high post-2001 productivity growth rate, not as warranting an upward revision of the Fed's interest-rate target, as neoclassical theory would suggest, but as an opportunity to maintain a below-natural interest rate target without risking a corresponding increase in inflation.

We supply lots of evidence supporting our interpretation and, thereby, supporting the view that excessively easy Fed policy did indeed contribute substantially to the subprime boom.   We also show how NGDP targeting would have prevented this outcome–and that it would have done so to an even greater extent than strict adherence to a Taylor Rule.

Readers familiar with my arguments favoring a "productivity norm," as presented in Less Than Zero and elsewhere, will understand the claims made here here as a specific application of those more general arguments.

The publishers have kindly allowed us to make the article available here without a pay wall for a brief period only; so consider saving it if you might want to have it for longer.


  1. Excellent work, thank you.

    It just puzzles me a little bit that it seems like monetary policy was "neutral" at the time of tech bubble crash?

    1. I'd say the real puzzle is that policy wasn't tight, according to our metric, during the tech boom itself. The crash generally involves a return to rates to their "natural" levels, if not an interval of excessively high rates. But as we show in the paper, the Fed did tighten more in response to that boom than it did in the early 2000s.

  2. There had also been the argument that there was pressure and reward on banks to make subprime loans to those with limited collateral. This was a politically directed motive to make housing expansion more inclusive. This became the air pocket that lifted the geometric trajectory of valuation for real estate. The expanded margins then lead to more expanded valuation followed by packing low collateralized mortgages into financial instruments based on the assumption that value of the underlying real estate assets would continue to increase. It really took off and later blew up. Politics can be a corrupting influence on banking integrity. It never will end.

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  4. Excellent article, which certainly provides solid theoretical basis as well as the empirical evidence to support the running of a different type of monetary policy rules; indeed different to the (CPI) inflation stabilising rules applied by all and sundry before 2008 which contributed to the recent crisis as well as to the instability generated in markets in the last years.
    It is time to apply less active and less inflationary monetary rules, those that allow the price level to reflect changes in productivity during expansions. Rather than focusing on price stability (actually it usually is inflation stability) we should be focusing on rules that better preserve monetary and financial stability on longer term basis; and the productivity norm is a good example of the latter. They are not going to be the cure for all problems but at least they will not be adding monetary disturbances on top of other (real-side) disturbances and shocks affecting the economy. And this will help agents form their expectations and make their plans.

    PS. It will reduce the power of central banks.

  5. George, I'm wondering if this is easily replicable for other countries, specifically Australia which itself is going through a housing boom (concentrated in two states and primarily in existing housing stock) in the midst of a collapse in commodity prices, collapse in its Terms of Trade and household net debt at c.154%. Really I would just try to replicate Figure 2 and Figure 5. Great work by the way.

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