In an interesting bit of synchronicity, we’re getting other “how did we get there” snippets from the global financial crisis today. Bloomberg reports that the Federal Reserve actually did see that a housing bubble was underway, but stuck to its guns of measured interest rate increases. The problem is that its account is far too kind to the Fed and comes awfully close to being revisionist history:
Federal Reserve staff and policy makers identified a housing bubble in 2005, and failed to alter a predictable path of interest-rate increases to slow down the expansion of mortgage credit, transcripts from Open Market Committee meetings that year show….
The FOMC in June heard presentations from staff economists, with some raising alarms about housing markets, the transcript shows. Those warnings didn’t translate into a more aggressive policy. The committee raised the benchmark lending rate a quarter-point at that meeting and said “policy accommodation can be removed at a pace that is likely to be measured.”..
“There was a fundamental failure of economic analysis to understand what was going on in the potential for house prices to stop rising,” said William Poole, the former St. Louis Fed president who attended the meetings in 2005. “The high degree of assurance that we all felt that house prices could not decline on a national average basis in a fundamental way — that was a significant mistake.”
You need to take this report with a fistful of salt:
1. William White of the Bank of International Settlements had been warning central bankers, including Greenspan, of a housing bubble in multiple markets since 2003
2. In June 2005 the Economist had a cover story, with a very detailed analysis, of the rise in housing prices. In other words, the idea that housing prices were frothy was clearly visible to mere readers of the financial press
3. Poole does accurately say that all the Fed did was consider that housing prices would stop rising, not that they might fall. This is another symptom of bubble denial and a major failure of imagination
4. It is not just that the staff warnings were largely ignored in terms of Fed policy, but it did not decide to engage in closer monitoring or do additional forensics. This again reflects the Greenspan “let the markets alone” anti regulatory bias. The Fed had other tools at its disposal besides interest rates. Jawboning or more intrusive inspections of bank would also have sent a message (yes, we know now that CDOs were the big driver of the toxic phase of the market, but a dim Fed view would have also influenced investors and would have led to a concern that the riskier tranches of RMBS were soon to be repriced, since risky debt usually takes it on the chin first when markets turn down. That could have led investment banks to be reluctant to gin up CDOs on a large scale, since they provided warehouse lines to CDO managers as well had exposure to unsold deals)
5. The Fed continued to defend the housing market in public statements. That’s the wrong thing to do; it tells investors and financial firms that the officialdom is on the case and thinks there is nothing to be worried about. For instance, ECONNED took note of this statement in a May 2005 speech, which is after the FOMC discussions in question:
Some observers have expressed concern about rising levels of household debt. . . . However, concerns about debt growth should be allayed by the fact that household assets (particularly housing wealth) have risen even more quickly than household liabilities. Indeed, the ratio of household net worth to household income has been rising smartly and currently stands at 5.4, well above its long-run average of about 4.8. . . . One caveat for the future is that the recent rapid escalation in house prices . . . is unlikely to continue. . . . If the increases in house prices begin to moderate as expected, the resulting slowdown in household wealth accumulation should lead ultimately to somewhat slower growth in consumer spending
The flaw in the logic is in plain sight. Consumer debts levels had continued to rise since the 1980s and the household savings rate had been hovering around zero. Debt has to be serviced out of income, liquidating savings, borrowing against other assets (a self-limiting process) or from the proceeds of asset sales. With real incomes of average consumers stagnant, a large number of consumers were in the position that everything had to work out right for them to be money good on their debt. We now know how this movie ended.
5. In the wake of the crisis, the Fed has continued to try to shirk blame for the crisis. The argument made all too often by the Fed and economists is that it’s impossible to see a bubble in progress and the officialdom can’t be expected to pop it. It was only when it became clear that policy thinking was moving in favor of macroprudential regulation that the Fed moved to protect its turf and started to act as if it was on board with taking on this role. I’m not entirely convinced of its enthusiasm for this job.
So now that the dirt is coming out, that the Fed did see the evidence of the housing bubble and continued to steer the Titanic at the same speed towards the iceberg, the nature and magnitude of its error is still being underplayed. But that should be no surprise. The fact that Bernanke remains at the helm of the Fed demonstrates that no one in any important pre-crisis role has been or will be held to account.