What Janet Yellen Did and Didn't Get Wrong About the Housing Bubble

It was the shadow banking more than the bubble that was the problem


There's always something delightful about a good straw man. Take Ethan Epstein of the Weekly Standard -- he thinks the praise Janet Yellen has gotten from myself and others for her pre-crisis prescience amounts to saying that she's "clairvoyant." Like I said, just delightful. Because it turns out she really can't see the future -- bet you didn't see that one coming -- and Epstein can prove it! Here's what he quotes her saying about the housing bubble back in 2005 to make his case:

In my view, it makes sense to organize one's thinking around three consecutive questions --three hurdles to jump before pulling the monetary policy trigger. First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?
My answers to these questions in the shortest possible form are, "no," "no," and "no."

This is the kind of thing that sounds worse than it is. See, Yellen's big error here wasn't underestimating what a deflating housing bubble would mean for the real economy, but rather what it would mean for the financial one. Back in 2005, she didn't appreciate how much shadow banks relied on AAA-rated mortgage-backed-securities (MBS) as collateral to fund their day-to-day operations -- or how much even this supposedly high-quality collateral could go bust if housing did. Of course, that's exactly what happened, and it set off a run on the shadow banking system that forced a fire sale of every other kind of asset, and, in the process, nearly ended the financial world as we knew it. But by 2007, Yellen, more than most at the Fed, had begun to realize these risks (though still not entirely). Heres' what she said at the Fed's policy meeting in December 2007

But if house prices and the stock market fall further and the economy appears to be weakening, then they will further tighten the lending conditions and terms on consumer loans to avoid problems down the road, and these fears could be self-fulfilling. If banks only partially replace the collapsed shadow banks or, worse, if they cut back their lending in anticipation of a worsening economy, then the resulting credit crunch could push us into recession.... Thus, the risk of recession no longer seems remote, especially since the economy may well already have begun contracting in the current quarter.

This is what Ben Bernanke calls the "financial accelerator": a manageable problem gets amplified by the financial system, becomes less so, and then gets amplified again as the cycle repeats itself. But the original problem, had it not been for this financial kerosene, would have otherwise been manageable. And that was true of the housing bust. It's easy to forget now, but the fall in housing prices was bad, but not is-this-the-end-of-capitalism bad for its first year or so. Falling home prices meant falling home construction and falling consumer spending, but these were problems the Fed could, and did, deal with -- until, of course, the financial system turned them into much, much bigger ones. Indeed, housing prices started falling in late 2006, but housing construction had started doing so well before that at the beginning of the year -- and the economy did just fine. As Scott Sumner points out, housing starts halved between January 2006 and April 2008, but unemployment only went from 4.7 percent to ... 4.9 percent.

But, of course, the story didn't stop there. Lehmangeddon turned what might have been a mild recession and a milder recovery -- think a worse 1991 -- into the worst crisis in 80 years. So what should have been done in, say, 2005 to have avoided this disaster? Well, Yellen is almost certainly right: the Fed should have tried to regulate away, not prick, the housing bubble. Things like cracking down on liar loans, tightening loan-to-value requirements, and toughening leverage ratios probably would have slowed the bubble, and made any subsequent bust less of a financial cataclysm. That would have been preferable to raising rates who knows how much to force a housing collapse sooner rather than later. That's what the Fed did in 1928, when it hiked rates to try to pop what it saw as a dangerous stock market bubble. It eventually succeeded at that -- and then some.

Look, Yellen wasn't perfect. She didn't realize how vulnerable the shadow banking system was to runs (though who did?). But she got more things right than she did wrong. And she quickly learned from the things she got wrong so that she made out the iceberg the economy was about to hit in late 2007 -- when many of her colleagues were still more worried about inflation. This intellectual flexibility is part of the reason she's had the best forecasting record of anyone at the Fed since 2009. And it's why she should be the top choice for Fed Chair.