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Home Publications Blogs Beat the Press The Fed Didn't Realize the Housing Bubble Was Driving the Economy

The Fed Didn't Realize the Housing Bubble Was Driving the Economy

Saturday, 19 January 2013 08:53

The Post and other news outlets wrote about the release of the transcripts from Federal Reserve Board's Open Market Committee (FOMC) meetings from 2007. The transcripts are striking with the FOMC members still largely oblivious to the collapse that was taking place around them.

I've not read through the whole set of transcripts, which probably exceed 1000 pages, but what is remarkable to me is a seeming complete failure to understand the extent to which the housing market was driving the economy. Housing construction had exceeded 6.0 percent of GDP at the peak of the bubble compared to an average of between 3.0-4.0 percent in the prior three decades. This was not explained by fundamentals. Similarly the saving rate had fallen to nearly zero compared to an average in the pre-stock bubble years of more than 8.0 percent.

The FOMC members were utterly clueless about the extent to which the bubble was driving the economy. It is therefore not surprising that they would be taken aback by the size of the hole created by its collapse. The overbuilding of the bubble years meant that construction would not just fall back to its normal level, but in fact well below as builders allowed excess supply to be filled. (It dropped to around 2.0 percent of GDP, a falloff of more than 4 percentage points.)

Consumption would naturally fall as the housing wealth that was driving it disappeared. The savings rate rose to above 5 percent in the wake of the downturn which corresponds to a loss of demand that is close to 4.0 percentage points of GDP. The combined loss in annual demand from these two sectors was close to 8 percent of GDP ($1.2 trillion in today's economy).

What did the FOMC members think could replace this lost demand? Housing and consumption together account for three quarters of the economy. There is nothing except the government that could fill a demand gap of this size, at least in the short term. In the longer term, net exports can increase enough to fill a gap of this proportion, but that was not going to happen overnight.

Remarkably, the FOMC folks were not even asking questions like this. That is scary.

Comments (10)Add Comment
written by skeptonomist, January 19, 2013 9:18
I have not read all the transcripts (and you can't make me), but it does not strike me as strange at all that the Fed directors should have been complacent about the state of the housing industry - they probably took it for granted that it was a triumph of their policy, pulling the economy out of the recession of 2001. It was one thing for outsiders to see that it had become dangerous, but Fed personnel had a personal investment in the success of boosting housing. Greenspan had always favored increased leverage and reduced regulation - why expect him to jump in with restrictions just when his policies seemed to be paying off? Bernanke had not been personally involved in the 2001-2006 policy, but his statements and speeches showed that he had an absurd overconfidence in the benefits of monetary policy; how it had supposedly brought stability to the economy, and how it could handle problems and prevent or cure major recessions.

The Fed is no more capable of regulating itself than any other institution. Regulation has to be automatic and carefully designed, not applied at the discretion of Randian crackpots appointed by Presidents who have no understanding of economics.
written by skeptonomist, January 19, 2013 9:26
I have read some transcripts from previous years and one thing which is striking is how little real critical and analytical thinking goes on. The directors are not really going over the facts and brainstorming to find new solutions, they are just putting prejudices on record and reaching a group judgement by the seat of the pants. Decisions tend to be conservative - just stick with what was being done for a while longer.
written by skeptonomist, January 19, 2013 9:32
Actually Bernanke was on the Board of Governors of the Fed 2002-2005, so housing was his policy too. It is against human nature to admit that a policy you authored (in part) has become dangerous.
written by PeonInChief, January 19, 2013 10:34
I can't imagine why anyone is surprised by this. In the heads of the middle class, the "real economy" is stocks, derivatives and other fancy financial instruments. Mortgages are something little people have, and so aren't important.

But I get to pat myself on the back. Unlike the masters of finance, I wrote Tenants and Foreclosure at the end of 2007, as I already knew we were in for some hard times.
written by Gerry Flaychy, January 19, 2013 11:17
"normal": 3-4% of GDP.

"before": 6%, or 2-3% over the "normal".

"after": 2%, or 1-2% under the "normal".

Seems to me as a return to "normal" !
written by urban legend, January 19, 2013 12:11
I don't think Flaychy understands the difference between per cent and percentage points. 6% is 50-100% higher than 3-4%. 2% is 50% lower
New Rule
written by dick c, January 19, 2013 1:20
Always look a gift horse in the mouth!
Housing Bubble? Housing Schmubble!
written by Ellen1910, January 19, 2013 2:34
Why, in 2007, should the Fed have been concerned, macroeconomically, with a housing bubble which was, all by itself, deflating and had been doing so since late 2005. That horse was long out of the barn.

If the 2007 Fed is to be criticized, it should be criticized for its failure to understand finance and banking. How is it possible that it did not know that the VaRs used by the banks were utterly wrong, that the CDSs that insured the banks' portfolios had been issued by ne'er-do-wells, that the MBSs the banks held were wildly over-valued? And how did it not know what would happen when these "unknowns" came to light?

Let's not forget that by the summer of 2007 Bear Stearns' two hedge funds that invested in CDOs and had insured them with CDSs had already blown up. Did the Fed notice?

2% of GDP
written by Gerry Flaychy, January 19, 2013 5:22
2% of GDP, whether over the average or under the average, is the same amount.
written by watermelonpunch, January 19, 2013 8:37
There's a difference between "ignorance" and "being in denial".

Back in 2005-2008... I had a family member in real estate in Southern California, and a boss & manager who talked about these things & another family member working in some kind of securities...
And they were all grumbling about various very scary or odd things they were seeing, and many comments were made during this time about housing prices not being right, etc.

At the time I understood very little about any of this.
So even though these tidbits were reaching me, I had no basic framework under which to process them.

I was ignorant.
And taken by surprise in late 2008.

And have spent hours upon hours over the past 4+ years trying to remedy that.

What these people were is not what you call "ignorant". It's what you call "denial".
Because really, they should've known better. They did know better. They just refused to admit it, maybe even to themselves...
But they were not just uninformed.

And it's ungenerous to the rest of us to even suggest that's all it was.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.