Why did the Fed miss all the warning signals?

We are going to once again return to the book highlighted the last few weeks, This Time Is Different, by Carmen M. Reinhart and Kenneth Rogoff. This is a book you should buy and read, especially the last 4-5 chapters, and try to get your Congressman to read it as well, so he or she can see what happens to countries that run up their debt. It makes no difference if it is small or large, the end result is the same.

Last week we looked at the role of confidence in allowing governments to borrow money. This week we ask whether Greenspan and Bernanke, along with the entire Fed, should have been able to determine whether a bubble was building in the US economy and lean against it, preventing the debacle we are now in. Reinhart and Rogoff gently come down on the side of those who think they should have, and that we need to implement changes in our institutions. Others, as we will see, are not so gentle. Let's look at a few selected paragraphs I pulled off my Kindle (all emphasis mine).

"As we will show, the outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicenter of the crisis, showed many other signs of being on the brink of a deep financial crisis. Other measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output - standard leading indicators of financial crises - all revealed worrisome symptoms. Indeed, from a purely quantitative perspective, the run-up to the U.S. financial crisis showed all the signs of an accident waiting to happen. Of course, the United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms.

"... On the one hand, the Federal Reserve's logic for ignoring housing prices was grounded in the perfectly sensible proposition that the private sector can judge equilibrium housing prices (or equity prices) at least as well as any government bureaucrat. On the other hand, it might have paid more attention to the fact that the rise in asset prices was being fueled by a relentless increase in the ratio of household debt to GDP, against a backdrop of record lows in the personal saving rate. This ratio, which had been roughly stable at close to 80 percent of personal income until 1993, had risen to 120 percent in 2003 and to nearly 130 percent by mid-2006. Empirical work by Bordo and Jeanne and the Bank for International Settlements suggested that when housing booms are accompanied by sharp rises in debt, the risk of a crisis is significantly elevated. Although this work was not necessarily definitive, it certainly raised questions about the Federal Reserve's policy of benign neglect.

"The U.S. conceit that its financial and regulatory system could withstand massive capital inflows on a sustained basis without any problems arguably laid the foundations for the global financial crisis of the late 2000s. The thinking that "this time is different" - because this time the U.S. had a superior system - once again proved false. Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the subprime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets, leading the International Monetary Fund to conclude in April 2007, in its twice-annual World Economic Outlook, that risks to the global economy had become extremely low and that, for the moment, there were no great worries. When the international agency charged with being the global watchdog declares that there are no risks, there is no surer sign that this time is different. [By that they mean that the attitude of the market in general and central bankers in particular was that "this time is different" and so we did not need to worry about the warning signs. The entire point of the book is that it is never different. We just somehow believe we are in a special situation.]

"... We have focused on macroeconomic issues, but many problems were hidden in the 'plumbing' of the financial markets, as has become painfully evident since the beginning of the crisis. Some of these problems might have taken years to address. Above all, the huge run-up in housing prices - over 100 percent nationally over five years - should have been an alarm, especially fueled as it was by rising leverage. At the beginning of 2008, the total value of mortgages in the United States was approximately 90 percent of GDP. Policy makers should have decided several years prior to the crisis to deliberately take some steam out of the system. Unfortunately, efforts to maintain growth and prevent significant sharp stock market declines had the effect of taking the safety valve off the pressure cooker.

"... The signals approach (or most alternative methods) will not pinpoint the exact date on which a bubble will burst or provide an obvious indication of the severity of the looming crisis. What this systematic exercise can deliver is valuable information as to whether an economy is showing one or more of the classic symptoms that emerge before a severe financial illness develops. The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. If the past we have studied in this book is any guide, these signals will be dismissed more often that not. That is why we also need to think about improving institutions.

"... Second, policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial."

The evidence is there. So why did the Fed miss it?

A more pointed critique is leveled at the Fed and Greenspan, and at Bernanke in particular, by Andrew Smithers in his powerful book (now updated) Wall Street Revalued: Imperfect Markets and Inept Central Bankers. The foreword is by one of my favorite analysts, Jeremy Grantham. This is on the top of my reading list for the coming week. I am loving the first part, which ties nicely into the themes explored by Reinhart and Rogoff.

The book is a withering critique of the Efficient Market Hypothesis (EMH), among other economic theories. Smithers argues that because the tenets of EMH are so ingrained, Greenspan and Bernanke could not recognize the bubble, because they believed in the efficiency of markets. "Dismissing financial crisis on the grounds that bubbles and busts cannot take place because that would imply irrationality is to ignore a condition for the sake of theory." Which they did.

As Grantham wrote in the foreword: "My own favorite illustration of their views was Bernanke's comment in late 2006 at the height of a 3-sigma (100-year) event in a US housing market that had no prior housing bubbles: 'The US housing market merely reflects a strong US economy." He was surrounded by statisticians and yet could not see the data... His profound faith in market efficiency, and therefore a world where bubbles could not exist, made it impossible for him to see what was in front of his own eyes."

Reinhart and Rogoff show time and time again that bubbles always end in tears. Markets and investors are in fact irrational. What kind of Fed governor would it have taken to suggest that housing was in a bubble and we were going to have to take steps to slow it down - raising rates, analyzing securitization and ratings? It would have taken one tough hombre. In fact, we had Greenspan, who encouraged the unchecked expansion of the securitized derivatives market. And a Congress that would not allow proper supervision of Fannie and Freddie (which is going to cost US taxpayers on the order of $400 billion). The list is long.

John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore

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missing warning signs I am not an economist but when house prices triple even a half whit should know a crash is coming. Who was the winners in the crash? The people with economic savvi, the losers are the average Jo that has put his trust in the Federal reserve and such . .more instituitions. I would like to know if Bernanke and other guys like him came out wealthier after this crash or poorer. I know what I am betting on. . .less by Neil on February 09 2010, 02:46 Find this comment inappropriate? Report it

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