CEPR - Center for Economic and Policy Research

The Financial Crisis: A Failure of Regulators, Not Regulations

Dean Baker
The Guardian Unlimited, November 16, 2009

See article on original website

The administration and Congress are in the middle of an effort to modernize financial regulation. Modernization is much needed, and if done correctly, will create a more transparent and efficient financial system. Unfortunately, much of the debate around reform centers on the idea that somehow the right set of regulations would have prevented the current crisis. That view is wrong in a very big way.

We got into this crisis because of a serious failure of the regulators, and more importantly the economics profession. The failure to come to grips with this reality both means that much of the regulatory reform effort will be misdirected and that we will have done little to prevent the next crisis.  

The central problem, which we should force every regulator to say 10,000 times, is that the U.S. had a huge housing bubble. The existence of an $8 trillion bubble guaranteed a severe economic downturn when it burst. This would have been true even if there were no dodgy subprime mortgages, exotic collaterized debt obligations, credit default swaps, or over-leveraged investment banks.

Bubble-inflated house prices generated close to $500 billion a year in excess housing construction. Bubble-created housing equity generated almost $500 billion a year in additional consumption. We don’t know how to quickly replace the $1 trillion in annual demand that disappeared with the collapse of the bubble. This is the reason that the U.S. economy now has 10.2 percent unemployment.

The financial fireworks of last fall and the parade of collapsing banking giants are sideshows. Financial shenanigans drove the bubble, but it is the bubble itself, not the financial shenanigans, that is responsible for the enormous suffering the country is currently experiencing.

This point is crucial. To prevent this crisis, our regulators only needed to recognize the bubble and take steps to burst it before it grew to such a dangerous level. If they knew arithmetic, they had all the tools needed to recognize the bubble. For 100 years, nationwide house prices had tracked the overall rate of inflation. Suddenly, in the mid-90s, house prices began to hugely outpace inflation, eventually rising by more than 70 percent after adjusting for inflation.

There was no remotely plausible explanation for this sudden surge in house prices. What did the regulators think had caused this extraordinary departure from a 100-year long trend in the largest market in the world if not a bubble? There was absolutely no excuse for the failure by the Fed and other regulators to see the housing bubble. What were they doing, playing video games the whole time?

If they saw the bubble, then there is also no excuse for failing to understand that its collapse would devastate the economy. Did they think that some force would magically grow up to replace the $1 trillion in bubble-driven demand?

The argument that they somehow lacked the tools to combat the bubble is absurd. If Greenspan-Bernanke had fully used the resources and the podium of the Fed to document and publicize the existence of the bubble, it probably would have been sufficient to prick it before the bubble grew to such dangerous levels. They also could have curtailed the reckless lending that everyone seemed capable of seeing except them. Finally, they could have threatened to raise interest rates as much as necessary to burst the bubble, and then carried through on the threat if necessary.

Instead, the Fed did nothing to combat the bubble – and it was applauded for doing nothing by the entire economics profession. This point is absolutely fundamental in understanding regulatory reform. Economists might be very smart and they may have prestigious degrees from top universities, but this crisis shows that most are incapable of independent thought. If they were, then they could not have possibly missed an $8 trillion housing bubble.

In a profession where everyone defers to authority, having more regulatory bodies with their own team of economists doesn’t provide a check on the Fed or anyone else. It just means that more taxpayer dollars will be wasted on economists who will all say the same thing.

That is why the most important regulatory reform is to fire the regulators who were out to lunch – starting with Ben Bernanke – thereby allowing this economic disaster. If we don’t fire the people that blew it, then we give the regulators no incentive to get it right next time. This is what basic economics tells us.

In short, we have a case where the fire department showed up at the burning school and then just went home. It may be the case that the equipment was old, but they still could have put out the fire if they had tried. It’s a good idea to get new equipment, but if the firefighters are not prepared to actually put out the fire, this effort will have been pointless. That appears to be the story of financial reform thus far. 
Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy. He also has a blog on the American Prospect, "Beat the Press," where he discusses the media's coverage of economic issues.