Wednesday, January 6, 2010

If the Fed Missed This Bubble, Will It See a New One?

The above question is being asked by NYT's David Leonhardt. In a column that is a mixed bag, what he gets right, he really gets right:
If only we’d had more power, we could have kept the financial crisis from getting so bad.

That has been the position of Ben Bernanke, the Federal Reserve chairman, and other regulators. It explains why Mr. Bernanke and the Obama administration are pushing Congress to give the Fed more authority over financial firms.

So let’s consider what an empowered Fed might have done during the housing bubble, based on the words of the people who were running it.

In 2004, Alan Greenspan, then the chairman, said the rise in home values was “not enough in our judgment to raise major concerns.” In 2005, Mr. Bernanke — then a Bush administration official — said a housing bubble was “a pretty unlikely possibility.” As late as May 2007, he said that Fed officials “do not expect significant spillovers from the subprime market to the rest of the economy.”

The fact that Mr. Bernanke and other regulators still have not explained why they failed to recognize the last bubble is the weakest link in the Fed’s push for more power. It raises the question: Why should Congress, or anyone else, have faith that future Fed officials will recognize the next bubble?

Just this week, Mr. Bernanke went to the annual meeting of academic economists in Atlanta to offer his own history of Fed policy during the bubble. Most of his speech, though, was a spirited defense of the Fed’s interest rate policy, complete with slides and formulas, like (pt - pt*) > 0. Only in the last few minutes did he discuss lax regulation. The solution, he said, was “better and smarter” regulation. He never acknowledged that the Fed simply missed the bubble...

When Mr. Bernanke is challenged about the Fed’s performance, he often points out that recognizing a bubble is hard. “It is extraordinarily difficult,” he said during his Senate confirmation hearing last month, “to know in real time if an asset price is appropriate or not.”

Most of the time, that’s true. Do you know if stocks will keep going up? Is gold now in the midst of a bubble? What will happen to your house’s value? Questions like these are usually an invitation to hubris.

But the recent housing bubble was an exception. By any serious measure, houses in much of this country had become overvalued. From the late 1960s to 2000, the ratio of the median national house price to median income hovered from 2.9 to 3.2. By 2005, it had shot up to 4.5. In some places, buyers were spending twice as much on their monthly mortgage payment as they would have spent renting a similar house, without even considering the down payment.

More than a few people — economists, journalists, even some Fed officials — noticed this phenomenon. It wasn’t that hard, if you were willing to look at economic fundamentals. You couldn’t know exactly when or how far prices would fall, but it seemed clear they were out of control. Indeed, making that call was similar to what the Fed does when it sets interest rates: using concrete data to decide whether some part of the economy is too hot (or too cold).

And Fed officials could have had a real impact if they had decided to attack the bubble. Imagine if Mr. Greenspan, then considered an oracle, announced he was cracking down on wishful-thinking mortgages, as he had the authority to do.

So why did Mr. Greenspan and Mr. Bernanke get it wrong?

The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were all saying that home prices would not drop, and the typically sober-minded officials at the Fed persuaded themselves that it was true. “We’ve never had a decline in house prices on a nationwide basis,” Mr. Bernanke said on CNBC in 2005.

He and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars, and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions. It’s an entirely human mistake.

Which is why it is likely to happen again.
I made a similar argument in July, 2008, and many times thereafter. It is good to see NYT catching up, but in this same column where Leonhardt recognizes the Bernanke/Fed brain freeze, it appears he suffers from the same affliction. He writes:
What’s missing from the debate over financial re-regulation is a serious discussion of how to reduce the odds that the Fed — however much authority it has — will listen to the echo chamber when the next bubble comes along. A simple first step would be for Mr. Bernanke to discuss the Fed’s recent failures, in detail. If he doesn’t volunteer such an accounting, Congress could request one.

In the future, a review process like this could become a standard response to a financial crisis. Andrew Lo, an M.I.T. economist, has proposed a financial version of the National Transportation Safety Board — an independent body to issue a fact-finding report after a crash or a bust. If such a board had existed after the savings and loan crisis, notes Paul Romer, the Stanford economist and expert on economic growth, it might have done some good.
Is he kidding? What makes him think that Bernanke and mainstream Keynesians have come out of the ether now? Leonhardt does not appear to understand that there is a legitimate business cycle theory that explains the boom bust cycle. Is this because he is caught in the same brain freeze, or has he never been exposed to the theory? Will somebody please send him a copy of The Mystery of Banking.

From there, Leonhardt goes from bad to worse and writes:
Whether we like it or not, the Fed really does seem to be the best agency to regulate financial firms. (It now has authority over only some firms.) As the lender of last resort, it already has a vested interest in the health of those firms. The Fed’s prestige also tends to give it its pick of people who want to work on economic policy.
At this point, it is clear he is in the same brain freeze. He is just throwing out prattle without thinking what other options might be. He doesn't address other options and why they might fail. He is just blindly stating the Fed is the best agency. Somebody, please, get brain deicer, i.e.The Mystery of Banking, over to NYT.


  1. The re-regulation debate seems (at best) to be a case of shutting the barn door after the horse has bolted.

    Of course implementing a smarter high tech barn door closing mechanism isn't going to help if you are asleep at the switch.

    The barn door metaphor is re-regulation at it's best. But for an Austrian, it's even worse than that. This may be a better metaphor.

    It's like inflating a zeppelin in a needle forest and when the inevitable happens, tracking down the one needle to blame and putting a band aid over it so it won't happen again. And then returning to the zeppelin pump.

  2. Thanks for this post. I think he needs to start off with Bastiat, Rothbard might be too much for him at the moment. It seems he needs some fundamentals on the seen and the unseen first and foremost.