The Federal Reserve is remarkably expert in the science of explaining tomorrow why the predictions it made yesterday didn’t come true today. As recently released transcripts of its 2006 meetings reveal, it’s also a perfect example of how much easier it is for people to work together when they have no idea where they are going – or what they’re doing.
The Washington Post reviewed those transcripts and highlighted a few aspects that are a combination of interesting, disappointing, and disturbing. It’s a short article and I recommend reading the whole thing, but here are a few of my takeaways:
1. The Fed leaders sound like a group of sycophants who spent an abnormal amount of time sucking up to Alan Greenspan. Granted, he retired that year, and I can understand the ceremonial aspect of expressing gratitude to a man who at the time was considered the “maestro” of the economy for his leadership in orchestrating two of the largest economic bubbles in our lifetime. But given that they are economists—a group not known for irrational exuberance–their praise seems a bit over the top. Secretary of the Treasury, Timothy Geithner, who was at that time the President of the Federal Reserve Bank of New York, said to Greenspan:
I’d like the record to show that I think you’re pretty terrific, too. . . . And thinking in terms of probabilities, I think the risk that we decide in the future that you’re even better than we think is higher than the alternative
The Washington Post does not indicate whether Geithner also sent Greenspan a valentine that year, but the nation’s highest ranking tax cheat was not alone in his admiration. As the Post continues:
The year began with adulation all around for Greenspan. In that January meeting, Roger Ferguson, then Fed vice chairman and now head of the TIAA-CREF financial services group, called Greenspan a “monetary policy Yoda.”
Janet L. Yellen, then president of the Federal Reserve Bank of San Francisco and now the Fed’s vice chair, told Greenspan “that the situation you’re handing off to your successor is a lot like a tennis racket with a gigantic sweet spot.”
2. The Fed leaders come across as victims of groupthink rather than deep economic thinkers with a responsibility to help manage the currency and economy. Economies are large, complex systems and there are many ways in which they can be analyzed and understood. It would be more comforting to know that there were factions within The Fed who were arguing about the meaning of various economic data. Even if those who rightly read the warning signs lost the policy arguments, it would be somewhat reassuring to know that somebody—anybody—at The Fed knew what was going on. Instead, sounds like the best and brightest were confident they had the situation under control.
Trusted to look toward the future and make decisions to keep the economy strong, they spent some of their time patting their leader on the back and even found time to joke about what turned out to be early-warning signs in the markets. While Fed officials — including several who are in key positions today — were aware that the nation’s rapid increase in housing prices was coming to an end, they significantly underestimated how much damage the popping of the real estate bubble would cause in the rest of the economy.
In his first meeting as Fed chairman, in March 2006, Ben S. Bernanke noted the slowdown in the housing market. But he said he shared the view that “strong fundamentals support a relatively soft landing in housing,” adding: “I think we are unlikely to see growth being derailed by the housing market.”
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In June 2006, the Fed still wasn’t totally aware of what was happening in the market. A Fed economist reported that “we have not seen — and don’t expect — a broad deterioration in mortgage credit quality.” That turned out to be an incorrect description of what was actually occurring.
The article does credit Former Fed Governor Susan Bies with being a “Cassandra,” in that she “warned that banks had built their models for ‘falling interest rates and rising housing prices.’” That’s an important insight, but it didn’t result in much of a warning. She’s reported to have said, “It is not clear what may happen when either of those trends turns around.” That’s a bit like saying it’s not clear what will happen if your costs go up, demand for your services go down, and a great deal of your accounts receivable becomes bad debt. Bernanke later responded:
So far we are seeing, at worst, an orderly decline in the housing market; but there is still, I think, a lot to be seen as to whether the housing market will decline slowly or more quickly.”
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At the end of the year, officials were still optimistic. “The current weakness in the economy still seems principally to stem from the direct effects of the slowdown in housing on construction activity” and other factors, Geithner said in December 2006. “The softer-than- expected recent numbers don’t argue, in our view, for a substantial reassessment of the risks in the outlook.”
3. The Fed is slow to admit its role in the economic meltdown
In the six years since, Greenspan’s record — seemingly so sterling when he left the central bank after 18 years — has come under substantial criticism from outside economists and analysts. Many say a range of Fed policies under his watch contributed to the financial crisis, including keeping interest rates low for too long, failing to take action to stem the housing bubble and allowing inadequate oversight of financial firms. . . .
Greenspan has acknowledged in recent years that he was “partially” wrong for allowing banks to operate without enough regulation. Bernanke has defended the Fed’s decisions about interest-rate policy and the overall economy but said that “stronger regulation” would have been “more effective” at constraining the housing bubble.
Without saying what regulations he would have passed, his comment strikes me as being little more than an attempt to salvage his reputation by blaming others for responding to perverse incentives created by cheap money. If only if he’d taken Ron Paul’s job advice back in 1999 …
On another note, the Washington Post article says, “Throughout the year, the Fed was slow to realize what was happening in the housing market and the threats it posed, as borrowers who took on risky subprime loans defaulted, causing foreclosures.” This is absolutely wrong. Not a single borrower took on a “risky subprime loan.” Perfectly good loans were given to risky subprime borrowers, and it was only by virtue of being given to subprime borrowers that the loans became subprime loans.