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Tuesday, February 9, 2010

False Profits: We Will Be Suffering from Greenspan and Bernanke's Ineptitude for a Long Time


An $8 trillion housing bubble fostered by the Federal Reserve has burst, and with it much of the wealth of America's middle class

February 9, 2010 |

The following is an excerpt from Dean Baker's new book: False Profits: Recovering from the Bubble Economy (PoliPointPress, 2010).

As the nation struggles to recover from the worst economic downturn since the Great Depression, the people who got us here are desperately working to rewrite history. The basic story of this economic collapse is very simple. The Federal Reserve Board, guided by its revered chairman, Alan Green span, allowed an $8 trillion housing bubble to grow unchecked.

Arguably, the Fed even fostered the bubble's growth, seeing it as the only source of dynamism in an economy that was suffering from the aftershocks of the collapse of a $10 trillion stock bubble. Greenspan repeatedly insisted that the housing market was just fine, even as a small group of economists and analysts raised concerns about the unprecedented run-up in house prices. He also dismissed concerns about the questionable mortgages the banks were issuing on a massive scale during the bubble years. In fact, he even encouraged people to take out adjustable-rate mortgages (ARMs) at a time when fixed-rate mortgages were near a 50-year low.

...[T]he devastating consequences for the economy of the collapse of the housing bubble were inevitable. Housing wealth, unlike stock wealth, is relatively evenly distributed among the population. For the vast majority of middle-class families, home equity is their financial asset. When the collapse of the bubble resulted in the disappearance of $8 trillion of housing bubble wealth ($110,000 per homeowner on average), tens of millions of homeowners had no choice but to sharply curtail their consumption.

The wealth that homeowners had taken for granted during the bubble years was gone. This meant that these homeowners could no longer borrow against home equity to support their level of consumption and that they would need to hugely increase their savings to rebuild the wealth they had lost. The rapid falloff in consumption, coupled with the collapse of housing construction, guaranteed the onset of a severe recession. There is no simple way to offset the loss of more than $1 trillion in annual demand in the economy -- $450 billion in lost housing construction and between $600 billion and $800 billion in lost consumption.

A massive wave of foreclosures and mortgage-loan defaults are also an inevitable parts of this story. Millions of people would have lost their homes even without the tsunami of junk loans the banks issued during the bubble years. When house prices plunge below the value of the mortgage, homeowners have less means and incentive to struggle to meet their payments. The huge job loss from the recession also propelled the massive wave of foreclosures.

None of this is complicated or mysterious. Anticipating this disaster didn't require brilliant insights or complex models. In fact, a good student in an introductory economics course would have possessed all the knowledge needed to see this train wreck coming.

However, the political elites do not want the official story to be that simple. They don't want the public to know that the people holding the top economic policy positions are incompetent, corrupt, or both. By burying the story in complexity, these elites are trying to confuse the American public. The confusion begins when the media and the politicians routinely refer to the recession as a "financial crisis."

The implication is that the financial system is at the root of the problem and that fixing the financial system is the way to restore the economy to its normal growth path. Although the failings of financial regulation certainly allowed the bubble to grow much larger than otherwise would have been possible, and the troubles in the financial system have aggravated the downturn, the current economic situation would be little changed if the financial system were instantly restored to perfect health.

The core problem is that the economy developed serious imbalances as a result of the growth of the housing bubble. In the short term, the only way to offset the loss of demand caused by the collapse of the housing bubble is through massive deficit spending. In the longer term, a reduction in the value of the dollar will be necessary to restore more balance to our U.S. trade. However, the political elites, led by the managers of the financial industry, do not want to allow for a discussion that results in a policy prescription of large deficits and a lower valued dollar. Such policies would go directly against their financial interests and directly indict the policy agenda they have promoted for more than a decade.

Rather than let people see the simple story, the political elites are anxiously touting the complexity of the situation. They want to focus the debate on complex derivative instruments like "credit default swaps" (CDSs) or "collaterized debt obligations" (CDOs). In this way they hope to quickly confuse, and lose, the public. They can then assert that the problems were so complicated no one could be blamed for not having foreseen them. After all, we're only human, and no one can predict the future. [...] The elites should not be allowed to perpetuate the falsehood that it was not their fault. Their failure to recognize the housing bubble or to have taken the steps necessary to rein it in before it grew to such dangerous levels brooks no excuse. Tens of millions of people have lost jobs, life savings, or homes because of this incredible failure on the part of the country's top economic policymakers. The people who are responsible for this disaster should be held accountable for the damage they have wreaked on the nation and the world.

In fact, the best way to prevent another bubble would be to fire the people responsible, but such a measure is highly unlikely. The list is long of people who should have known better and could have taken steps to counter the bubble before it grew to such dangerous proportions. Ben Bernanke, the chairman of the Federal Reserve Board during the last phase of the bubble, would top that list.

Bernanke was one of the seven members of the Fed's Board of Governors from 2002 until June 2005. In this capacity, he could have challenged Alan Greenspan's decision to allow the bubble to grow unchecked. Bernanke subsequently became head of President Bush's Council of Economic Advisors, where he served for seven months before returning to the Fed as chairman in January of 2006. The entire time from 2002 he sat back and allowed the bubble to grow. He never took any steps to rein it in, nor did he issue any warnings to the public about the potential consequences of its collapse. It would be difficult to imagine someone with a comparable record of disastrous failures being allowed to remain in most jobs. Would a nurse who routinely administers the wrong medicine and causes his patients to die be allowed to keep his job? Would a bank teller who leaves the cash drawer open remain in her position? How about the school bus driver who comes to work drunk?

In most lines of work, a certain level of competence is expected. Unfortunately, this is not the case for those who set U.S. economic policy. In political circles, the idea that Ben Bernanke should lose his job because he didn't take action to counter the bubble is considered absurd.

Bernanke was not, by any means, the only one who should have been trying to counter the bubble. Considering the dire consequences of the bubble's collapse, this was the most important thing anyone in a policy position should have been doing. Washington is chock full of people working on economic policy in positions at the Treasury, the Fed, the various regulatory agencies, and elsewhere who earn six-figure salaries. They all failed to see or issue warnings about the housing bubble. Not one of these people has gotten fired. In fact, not a single person involved in economic policy has probably even missed a promotion because of this gross failing.

This view -- that the collapse of the housing bubble caused the economic collapse and subsequent recession -- is completely different from the commonly discussed view that the abundance of bad mortgages was the main problem. Bad mortgages fed the bubble and allowed it to reach much more dangerous proportions. The core problem, however, was the bubble itself, not the mortgages. If all the mortgages had met normal prudential standards, but we had a bubble of the same proportions, the economy would still be in pretty much the same situation as it is today.

Conversely, if we had the same flood of bad mortgages and no bubble, the consequences would have been more limited, even for the homeowners who took out these mortgages. In many cases, they would have been able to refinance into standard fixed-rate mortgages. Even if refinancing had been impossible because of a bad credit or employment situation, homeowners might have been able to sell their homes and pocket some equity, rather than being forced into foreclosure.

In order to assign correct blame and to design proper reforms, it is essential to distinguish between the bubble as the primary cause of the crisis and the bad mortgages themselves. Although the flood of bad mortgages was evident to those who cared to look, an $8 trillion housing bubble should have been impossible to miss for any serious economic analyst. The point is that we do not need supersleuth regulators and analysts to uncover similar problems before those problems crash the economy, but we do need policymakers who are smart enough to walk and chew gum at the same time.

Creating new agencies is not the answer; forcing the agencies that are responsible for maintaining economic and financial stability (first and foremost the Federal Reserve Board) to do their job properly is. The Fed could have and should have stopped the growth of the housing bubble long before it reached such enormous proportions. Its failure to do so was perhaps the single most consequential error in economic policy in the history of the world.

Going forward, the Federal Reserve Board must clearly be responsible for preventing asset bubbles -- such as the stockmarket bubble and the housing bubble -- from posing a threat to the economy. Contrary to assertions from former Federal Reserve Board Chairman Alan Greenspan, recognizing such bubbles is not only possible but it is precisely what the Fed is supposed to do. And, once it recognizes a bubble, the Fed has all the power it needs to deflate it.

Many other changes should result from this experience. Most importantly, the country needs to rein in a financial sector that has grown out of control, nearly quadrupling its share of the economy over the last three decades. This sector accounted for almost 30 percent of all corporate profits at the peak of the housing bubble.

Ideally, the financial sector funnels money from people who want to save it to those who want to borrow it to start or expand a business or to pay for a home or a college education. Thirty years ago, this country's financial sector accomplished this mission very well, and the economy had a much more rapid pace of productivity growth than in the last three decades.

A financial sector brought back down to size will carry out its economic function much more efficiently. The United States doesn't need a financial sector that prospers through the creation and trading of complex financial instruments of little economic value. A reduction in the size of this sector would also make it less powerful and prevent it from exerting political control over those who are supposed to regulate it.

Part of the problem is that the sector's control over regulators is actually built into the system. The Fed is structured so that the private-sector banks dominate the boards that control the 12 Fed district banks that comprise the Federal Reserve System, along with the Board of Governors located in Washington DC. These boards then select the Fed district bank presidents. These 12 bank presidents sit on the Fed's Open Market Committee, which determines interest-rate policy outnumbering the 7 Fed governors who are appointed by the President and approved by Congress. (Only 5 of the 12 bank presidents vote at any one time.) This arrangement is akin to the pharmaceutical industry picking members of the Food and Drug Administration (FDA). Congress must democratize the Fed by rewriting its charter.

As we push for reform, it is important to avoid framing the debate -- as conservatives routinely do and progressives foolishly accept -- as a conflict between those who want more government control versus those who want market control.

Despite what they say to sell their policies to the public, conservatives have never been interested in reducing the role of government and "leaving things to the market." In reality, they want the government to structure the market to facilitate the redistribution of income upward.

Progressives do the conservatives' bidding when we denounce them as "market fundamentalists." We should, instead, be exposing their use of government to set up structures that ensure the market works to benefit the wealthy. We could then bring our policies into focus as those designed to ensure that market outcomes will benefit the bulk of the population.

The market is just a tool, like a wheel or a hammer. It would be bad politics and bad policy for progressives to make a big scene attacking the wheel. It is similarly bad politics and bad policy to put these attacks on the market at the center of a political agenda.

False Profits: Recovering from the Bubble Economy © 2009 by Dean Baker. Reprinted with permission from PoliPointPress, LLC, Sausalito, CA

Dean Baker is co-director of the Center for Economic and Policy Research and author of the new book, False Profits: Recovering from the Bubble Economy (PoliPointPress, 2010).

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