Yesterday, I mentioned one criticism of Bernanke's tenure as Federal Reserve chief -- that he isn't focusing enough on curbing unemployment. Another common one is that he (and his predecessor) failed to pop the real estate bubble before it grew too large. Didn't some of those brilliant economists at the Fed fear that a gigantic housing bubble was forming? Should they have taken the initiative to pop it before it grew large enough to bring about a massive financial crisis?
These questions were asked to Wall Street Journal economics editor David Wessel in an interview with the Big Think as part of its special series on the financial crisis called "What Went Wrong?" The series consists of several weeks of interviews of figures in the financial industry.
In answering a question about how the Fed failed to see the housing bubble, Wessel touches on the broader question of how it should act when it notices a bubble forming:
I think that when you go back and look at what was going on inside the Fed, there were people who warned that this was a housing bubble. But, they were not convincing and the reigning view at the Fed was, even if it is a bubble, we shouldn't interfere with it. We should let the markets do their thing and if it bursts, it will be as Bernanke and Paulson said in late 2007 even, it'll be contained. And they were comforted by the fact that when the tech stock bubble had burst earlier in the 2000's, it had done a lot of damage to people who had bought a lot of internet stocks, but it hadn't really done a lot of damage, lasting damage, to the economy. And so they looked at it as they looked at that. So, it was not only a failure of analysis, it was failure of ideology in the best sense, a world view that led them to believe that even if there was a housing bubble, they shouldn't do anything.
Of course Bernanke and everyone else who was taken seriously at the Fed were wrong that a housing bubble wouldn't be that big of a deal. But I think Wessel's point about what the Fed learned form the tech bubble misses something. I believe it goes beyond the Fed's observation that the tech bubble did not causing much lasting economic destruction.
In fact, the Fed played a part in popping the internet bubble. Consequently, many blamed the Former Fed Chairman Alan Greenspan for causing the recession that followed. And the anger in the market that resulted from that action might have been what prevented the Fed from treating the real estate bubble far less aggressively. I don't think the "failure of ideology" was based on theory or principle, but on appeasing the market. (See the end of this post for additional analysis of these two bubbles and the Fed's actions.)
But really, there was an even graver problem here: ideology might have been trumped if the Fed's analysis was better. An industry specific equity bubble is fundamentally different from a housing bubble -- not realizing that was its "failure of analysis." For starters, all investors know growth stocks contain a lot of risk, but real estate was historically touted as the safest of assets, almost never decreasing in value. There also wasn't a trillion dollar asset-backed market based on tech stocks, with its highly-rated bonds having complex structures that investors didn't fully grasp.
When tech stocks went bad, investors lost money, some dotcom's failed, and that was it. It didn't really affect Main Street. But you can't get much more Main Street than houses. Yet, Wall Street was even more deeply entrenched due to mortgage-backed securities and other structured products. And then investors panicked, because they didn't understand those assets or know how much of banks' portfolios were bad from toxic securities. That's why a housing bubble turned out to be far more dangerous than a sector-specific equity bubble.
Clearly, the Fed miscalculated just how interconnected the housing market was and the kind of fallout that would result when prices declined nationally by over 30%. But that's a justified correction, given how irrationally home values had risen. The Fed should have behaved like it did with the tech bubble, and prevented the housing bubbles from inflating as soon as home prices were clearly increasing far more rapidly than history has proven to be reasonable. Unfortunately, I think the Fed was uncomfortable doing so, because it did not want to be held responsible for causing another recession. In the retrospect a little recession in 2005 would have been quite a bit less painful than a financial crisis three years later. Of course, hindsight is always 20-20.
Additional analysis of the two bubbles:
In mid-1999, the Federal Reserve began slowly raising the Federal Funds Rate as the internet bubble inflated. Eight months later, the internet bubble began to pop. At that time the Fed continued raising rates another point from 5.5% to 6.5%, where it left it for six more months. During that time period, the Nasdaq lost over 50% of its value. The diagram below shows this:
Of course, many people were quite angry with the Fed. Some blamed Former Fed Chairman Alan Greenspan for causing the recession that followed. Let's compare what happened with the tech bubble and the housing bubble. Here's a similar graph with S&P/Case-Shiller's U.S. national housing price index versus the Federal Funds Rate:
(I apologize for the smoothness of the Fed Funds curve -- it should be a step function. But since the housing index was only quarterly, I couldn't get it any more exact in Excel.)
As you can see, the housing bubble was allowed to take off to a far greater extent than the internet bubble did. From Q1-2002 through Q2-2004, the Fed was decreasing the rate or leaving it constant. Meanwhile, the index shows housing values having increased by 30% over that period -- in just nine months. For the next six months rates increased, but still remained relatively low, not to exceed 4% until December 2005 -- as the index increased an additional 22%. But as the internet bubble grew in 1999 through mid-2000, rates started at 4.75% and increased to 6%, then left at 6.5% for six months even after the tech market's collapse.
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