Why the Fed Slept On the Housing Crisis

The recent release of the 2006 transcripts of the Federal Reserve's main policy-making body stimulated a small media frenzy. "Little Alarm Shown at Fed at Dawn of Housing Bust," headlined the Wall Street Journal. The Washington Post agreed: "As financial crisis brewed, Fed appeared unconcerned." The New York Times echoed: "Inside the Fed in '06: Coming Crisis, and Banter."

Comments from members of the Federal Open Market Committee (FOMC) now seem misguided. The first 2006 meeting was the last for retiring Fed Chairman Alan Greenspan. Janet Yellen - then president of the Federal Reserve Bank of San Francisco and now Fed vice chair - said "the situation you're handing off to your successor is a lot like a tennis racket with a gigantic sweet spot." Treasury Secretary Timothy Geithner - then head of the Federal Reserve Bank of New York - called Greenspan "terrific" and suggested his already exalted reputation might grow even more. There was no sense of a gathering crisis.

All true, but it begs the central question: Why? The FOMC members weren't stupid, lazy or uninformed. They could draw on a massive staff of economists for analysis. And yet, they were clueless.

It wasn't that they didn't see the housing boom or recognize that it was ending. At 2006's first meeting, a senior Fed economist noted "that we are reaching an inflection point in the housing boom. The bigger question now is whether we will experience (a) gradual cooling . . . or a more pronounced downturn."

At that same meeting, Fed Governor Susan Bies warned that mortgage lending standards had become dangerously lax. She explained that monthly payments were skyrocketing on mortgages with adjustable interest rates. She worried that many borrowers couldn't make the higher payments. The flagging housing boom concerned many Fed officials.

But they - and most private economists - didn't draw the proper conclusions. Hardly anyone asked whether lax mortgage lending would trigger a broad financial crisis, because America had not experienced a broad financial crisis since the Great Depression. A true financial crisis differs from falling stock prices, which are common. A financial crisis involves the failure of banks or other institutions, panic in many markets and a pervasive loss of wealth and confidence.

Such a crisis was not within the personal experience of members of the FOMC - or anyone. Nor was it part of mainstream economic thinking. Because it hadn't happened in decades, it was assumed that it couldn't happen. There had been previous real estate busts. From 1964 to 1966, new housing starts fell 24 percent; from 1972 to 1975, 51 percent; from 1979 to 1982, 39 percent; from 1988 to 1991, 32 percent. Declining home construction had fed economic slowdowns or recessions. So the natural question seemed: Would this happen now? The answer seemed "no." The overall economy was strong. This is the most obvious reason for an oblivious FOMC.

But it is not the main reason, which remains widely unrecognized. Since the 1960s, the thrust of economic policy-making has been to smooth business cycles. Democracies crave prolonged prosperity, and economists have posed as technocrats with the tools to cure the boom-and-bust cycles of pre-World War II capitalism. It turns out that they exaggerated what they knew and could do.

There's a paradox to economic policy. The more it succeeds at prolonging short-term prosperity, the more it inspires long-run destabilizing behavior by businesses, banks, consumers, investors and government. If they think basic stability is assured, they will assume greater risks - loosen credit standards, borrow more, engage in more speculation, relax wage and price behavior - that ultimately make the economy less stable. Long booms threaten deep busts.

Since World War II, this has happened twice. In the 1960s, the so-called "new economics" promised that, by manipulating the budget and interest rates, it could stifle business cycles. The ensuing boom spanned the 1960s; the bust extended to the early 1980s and included inflation of 13 percent, four recessions and peak monthly unemployment of 10.8 percent. The latest episode was the so-called Great Moderation, largely paralleling Greenspan's Fed tenure (1987-2006), when there were only two mild recessions (1990-91 and 2001). We are now in the bust.

The Fed slept mainly because it overlooked the possibility of boom-bust. It didn't recognize that its success at sustaining prosperity - for which Greenspan was lionized - might sow the seeds of a larger failure. It bought into an overblown notion of economic "progress."

The Great Moderation begat the Great Recession. One implication is that an economy less stable in the short run becomes more stable in the long run by reminding everyone of risk and uncertainty. Sacrificing long booms may muffle subsequent busts. But this notion appeals to neither economists nor politicians. Ironically, the central lesson of the financial crisis is ignored.