What the Fed Did (and Didn't) Know

On Sept. 18, 2008, Federal Reserve Chairman Ben Bernanke stood before a group of key policymakers and warned: "I am a student of the Great Depression. Let me state clearly: If we do not act in the next few days, this will be worse than the Great Depression."

Ten months earlier, on Dec. 11, 2007, the Fed's Open Market Committee met to discuss the state of the economy. Forget the Great Depression. "Overall," Fed economist David Stockton briefed Bernanke, "our forecast could admittedly be read as still painting a pretty benign picture: Despite all the financial turmoil, the economy avoids recession."

In hindsight, the economy entered recession that very month.

When digging through the just-released transcripts of the Fed's 2007 policy meetings, you can't help concluding that the small group of policymakers who in so many ways hold the keys to the nation's economy was basically clueless.

"Market participants know a lot more now than they did before. Thus, fear is diminishing, which implies less risk of a crisis developing from this source," said William Dudley.

"My forecast for the most likely outcome for output over the next few years is ... growth a little below potential for a few quarters, held down by the housing correction, and the unemployment rate rising a little further," said Vice Chairman Donald Kohn.

During the Fed's July 2007 meeting, the word "recession" was used three times, all referring to past recessions, while the word "strong" was used 61 times, most referring to the then-current state of the economy.

"I think it's fair to say that part of our mistake in 1998 was a failure to appreciate just how strong the U.S. economy was as we entered that period," said David Stockton. "Could we be making that mistake again? Possibly."

It almost takes your breath away.

But as Neil Irwin of The Washington Post wrote:

That's not to say they should have been predicting the gory details of what was to come ...

I did expect, though, that Fed officials would show more evidence of understanding the possibility that the entire financial system had become a house of cards built on mortgage securities that were anything but secure, with all sorts of financial institutions over-levered and overly dependent on assets that were near-impossible to value. And I expected them to understand that once a problem that deep begins correcting itself, it can spiral into all sorts of dangerous directions. Which this one did.

That's really the key here. No one should have expected the Fed to forecast that several Wall Street banks were months away from losing the confidence of overnight lending markets. Or that Barclays would be prevented from taking over Lehman Brothers because of a technicality in U.K. securities laws. Or that the combination of the two would cause a run on the money market industry. Specific events are impossible to predict. But really broad imbalances, like the one we had in credit last decade, don't hide themselves well. Peter Schiff pointed it out. As did Nouriel Roubini, Robert Shiller, Raghuram Rajan, and many others, including yours truly. None got all the details right. But they knew there were imbalances large enough to cause something ugly -- a basic position that most Fed officials were miles away from.

Sure, there were a few dissenters. "The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real," said Fed governor Janet Yellen (who is now vice chairman) in 2007. Treasury Secretary Tim Geithner, who at the time worked at the New York Fed, was more cautious than most and quick to warn that bank conditions were tightening.

But they were the exceptions, and the difference between them and the common view of Fed officials wasn't in the degree of pessimism, but in having any pessimism at all. No one should expect economists to be on the same page, but in hindsight it's shocking how many were reading entirely different books.

Many have wondered why the Fed only releases the minutes of its meetings with a five-year lag. When you compare its past forecasts with what happened in reality, it's easy to see why.


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  • Report this Comment On January 23, 2013, at 10:40 AM, TMFGortok wrote:

    Their own minutes prove why a centrally planned economy is doomed to fail. Or, more accurately: Doomed to a boom and bust cycle created by injecting credit to artificially boost production. A house of cards, indeed!

  • Report this Comment On January 23, 2013, at 11:28 AM, slpmn wrote:

    ^ I think you need to elaborate on how things would have been better in 2008 had the "central planners" not been around. Centrally orchaestrated moves were critical to stopping the fall.

    If you're suggesting they caused the crisis, well, that's naive at best.

  • Report this Comment On January 23, 2013, at 12:15 PM, TMFGortok wrote:

    @slpmn It all depends.

    If we didn't have a Federal Reserve, and our money was sound, then a credit expansion could not have pervasively infiltrated every sector of our economy; but that would have also required the death of fractional reserve banking and the FDIC (among other 'safety' nets that just encourage risk taking with other people's money). Because these comments aren't a great place to write an entire book on the ills of the Federal Reserve, I can leave you with an entire trove on the subject, if you wish.

    On this specific topic, remember that in 1919, just after the inception of the Federal Reserve, there was a crash. The government did very little (almost nothing), and the economy recovered in just two years. Contrast that with today, where the government (Yes, the Federal Reserve is a government entity, all protestations to the contrary notwithstanding) has tried to prop up house prices by buying up Mortgage backed securities; and through keeping interest rates impossibly low. Yet, 4 years later, we're still in a recession, and even our best central planners have no idea how long we'll be in one.

    If the crash was allowed to occur, and bankruptcies allowed the debt to liquidate, we would be out of this mess by now. It is precisely the Government scratching the back of Wall street that has helped Wall Street at the expense of everyone else -- especially people on fixed incomes.

    Just because a bankruptcy happens does not mean the world ends: If your mortgage lender goes bankrupt, someone buys up that debt (usually for pennies on the dollar). If you can't pay your mortgage, you declare bankruptcy or are foreclosed on; and no one else is made to pay for your hubris. More importantly, even though you lost your house, you will have the money to rent (because you were smart enough to declare bankruptcy when you were, in fact, bankrupt) -- and an importantly life lesson will have been learned.

    Those 'centrally orchaestrated moves' may have prolonged the agony, but they haven't stopped the inevitable correction by any means -- they just make it more painful when it finally hits.

    And I'm not suggesting the Federal Reserve helped cause the crisis, I'm saying it outright.

    The artificially lowered interest rates were the sine qua non to the financial crisis. Without those low rates, the credit expansion could not have happened -- it would have been too expensive to the banks and to the people who were loaned money! Couple that with the implicit guarantees for Freddie and Fannie, and you have a perfect storm brewing where government says, "Sell everyone houses!", the Federal Reserve enables it through really low (almost zero percent interest rates), and big business says, "This is crazy, but we're making a lot of money off of it, so why stop". They then say, "Hey, let's just create a Credit Default Swap in case things go south" and then when things inevitably go south, the American taxpayer gets stuck holding the bag -- instead of the entities responsible.

    That's why I call it a house of cards, because that's exactly what artificially lowering interest rates does to the economy: it creates a house of cards.

  • Report this Comment On January 23, 2013, at 12:17 PM, TMFMorgan wrote:

    <<If the crash was allowed to occur, and bankruptcies allowed the debt to liquidate, we would be out of this mess by now. >>

    There was a crash. Bankruptcies surged, and we're in the middle of the biggest debt deleveraging in history.

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