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

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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.