lifestyle leader

Bernanke's speech in Atlanta last week spread throughout the blogosphere like wild fire, and the reaction was not positive. The Fed chief defended US monetary policy in the run-up to the financial crisis and claimed that lax regulation, not interest rates, inflated the housing bubble. A chairman of the Fed defending the bank's record and competence against a backdrop of political hostility and regulatory reform is not surprising. Bernanke's position that prolonged low interest rates played no role in the housing bubble is more so.

But after reading the Fed staff working paper that accompanied Bernanke's speech, the folks at Free Exchange believe that, interest rate correlation aside, the Fed's worldview has been quietly transformed. The Fed's analysis featured three names: Shiller, Kindleberger and Minsky. For those unfamiliar with these men, they are three of most prominent advocates of the idea that markets are imperfect, unstable and subject to psychology (hence the title of Kindleberger's book Manias, Panics and Crashes). This is downright antithetical to the Fed's prevailing ideology, and their acceptance could represent an important shift in the Fed's understanding of markets and its role in influencing them. I can assure you that Alan Greenspan would have neither reached nor endorsed their conclusions, and a search of the Fed's website by Free Exchange found only two previous references to Minsky and just one to Kindleberger.

Paul Krugman agrees with Bernanke that there were compelling reasons for 2002-2006 monetary policy. But this doesn't mean that the policy didn't contribute to the housing bubble, or that the Fed failed to act on the warning signs. Krugman faults Bernanke for not acknowledging the inadequacies of the Fed's prevailing wisdom before the crisis and admitting that they all missed the housing bubble. On this measure his speech was disappointing, particularly for those of us who support a second-term. But by digging beneath the headlines, Free Exchange has highlighted an important shift in the Fed's institutional understanding of markets, regulation and monetary policy, one that is hopefully diffused throughout the policy and academic establishment.