Zywicki in WSJ: Federal Reserve's Policies Changed Consumer Behaviors

Writing in an online symposium in The Wall Street Journal, Professor Todd Zywicki refuted former Federal Reserve Chairman Alan Greenspan's assertion in a March 11 op-ed that the Federal Reserve's policies on short-term interest rates had no impact on long-term mortgage interest rates.

Conversely, says Zywicki, Greenspan overlooked the way in which the Federal Reserve's policies changed consumer behavior, explaining that the artificial lowering of short-term interest rates led to increased choice of ARMs by consumers, who also engaged in risky market behaviors made attractive by the low rates and existing tax policies. Many were hurt when the interest levels rose back up to the level of FRMs, making many loans unaffordable and resulting in a wave of foreclosures and falling home prices.

Low Rates Led to ARMS, The Wall Street Journal, March 26, 2009. By Todd J. Zywicki.

"Record-low ARM interest rates kept housing generally affordable even as buyers could stretch to pay higher prices. Low short-term interest rates, combined with tax and other policies, also drew speculative, short-term home-flippers into certain markets. As the Fed increased short-term rates in 2005-07, interest rate resets raised monthly payments, triggering the initial round of defaults and falling home prices. Foreclosure rates initially soared on both prime and subprime ARMS much more than for FRMs.

"Why did the ARM substitution result in a wave of foreclosures this time, unlike prior times? During previous times with high percentages of ARMs, the dip in short-term interest rates was a leading indicator of an eventual decline in long-term rates, reflecting the general downward trend in rates of the past 25 years. By contrast, during this housing bubble the interest rate on ARMs were artificially low and eventually rose back to the level of FRMs. There were other factors that exacerbated the problem -- most notably increased risk-layering and a decline in underwriting standards -- but the Fed's artificial lowering of short-term interest rates and the resulting substitution by consumers to ARMs triggered the bubble and subsequent crisis."

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