When economist Bob McTeer became president of the Federal Reserve Bank of Dallas, he got an inside look at how one of the world's most powerful institutions operates. It was February 1991 and the savings-and-loan crisis had caused what some people called a credit crunch in Texas. So Mr. McTeer and the Dallas Fed took the lead in discussions at the Federal Reserve’s Federal Open Market Committee (FOMC) about the economic phenomenon – an illustration of how the Fed uses its 12 district banks and their branches to track the national economy. “It’s sort of like the canary in the coal mines," McTeer explains. "Eventually, all this stuff will become part of the statistical apparatus, but before it has a chance to do that, it is sort of like an early warning system.” But occasionally, despite its in-depth tracking, sophistication, and size (with more than 300 PhDs, it's one of the largest concentrations of economists in the world), the Fed makes mistakes.
In this excerpt and adaptation from "Big Picture Economics: How to Navigate the New Global Economy" (Wiley, 2014), former Monitor reporter Ron Scherer and prize-winning economist Joel Naroff argue that one of the key factors to setting economic policy is context – that is, policymakers have to understand the factors powering the economy at any given time to choose the right policy. If they misjudge the context, trouble ensues:
Obviously, there is no such thing as normal monetary policy. Yet not all monetary policies make sense. The Federal Reserve under Alan Greenspan came to the conclusion that it could not or should not do anything about an economic bubble. When tech stocks soared in the 1990s and housing costs skyrocketed in the 2000s, the monetary authorities did little to slow the rises. The assumption was that restraining economic growth would cost the economy too much; it was not clear if the policy would succeed or that it was even possible to recognize a bubble until it actually burst.
The philosophy that the market knew best and the Fed should not interfere with it cost us dearly. It is fair to argue that the Great Recession was in no small part a consequence of the Federal Reserve blundering about home price increases and the effects of a housing bubble on the economy.
From bubbles to Fed meetings
McTeer recalls that Greenspan used to say that real estate is a lot of local markets instead of one national market. And while Greenspan might agree that there was some froth in some of those markets, McTeer recalls Greenspan “once humorously defined froth as little itty bitty bubbles.”
McTeer thinks the reason the Fed misunderstood what was taking place in the economy in 2007 was that it did not understand how loans being made to people with less than stellar credit, termed subprime loans, could bring the entire economy down.
Many of these loans were collected together in packages and resold to global investors who wanted to beef up the return to their portfolios with the high interest rates being paid by subprime borrowers.
Investors bought securities that were backed by assets – mortgages made to subprime borrowers. In theory, if the borrower defaulted, the home could be sold to cover the loan. However, no one figured that the default rates would drag home prices down by over 50 percent in some markets.
Some members of the FOMC certainly underestimated what was taking place in the economy, which was entering a steep recession.
According to the transcript of the September 18, 2007, meetings, released in 2013, some Fed district bank presidents were more concerned that the Fed was not adhering to its short-term interest rate target of 5.25 percent.
“I think allowing the fed funds rate to be so low for so long away from our target really creates a credibility problem for this committee,” said Dr. Charles Plosser, the president of the Philadelphia Fed. “It puts us in an awkward position now because, in effect, it hasn’t gone unnoticed by the investment community.”
Plosser was not alone. Gary Stern, president of the Minneapolis Fed, added his view that “when we establish a target, we have an obligation to achieve the target.”
In addition, the Fed underestimated what the impact of the collapse in the markets would be on the banking system. According to the transcripts from that September FOMC meeting, Bill Dudley, then the Fed’s manager of open market activities but soon to be the president of the Federal Reserve Bank of New York, told the members that the banks could have a potential earnings problem because of the disruption in their ability to syndicate loans.
However, Dudley told the committee, “I think the uncertainty about it will probably turn out to be more of a problem than the actual reality, but it’s going to take time for us to find out what the actual reality is.
The Fed goofs
As it turned out, the actual reality was far worse than anticipated. By October 2008, Congress had to authorize a $700 billion fund called the Troubled Asset Relief Program (TARP), which added capital to the banking system, helped prevent the collapse of the auto industry, and had to invest in the giant insurer AIG.
“From my perspective, one of the reasons people didn’t get what was going to happen is that they never connected very well in their minds the subprime loans that were being made to securitization,” says McTeer.
McTeer confesses he did not understand what was happening. “I remember in the early 1990s occasionally somebody would say banks are making loans that they know can’t be repaid. And I remember thinking, ‘Well, why would they do that?’ I did not fully understand ... that they would sell these loans as part of the securitization process. They just moved the risk to someone else.”
McTeer says people in the Fed did in fact worry that there was a real estate bubble. But he says the view was that “what goes up can go back down, and there was no reason to expect it to be so catastrophic.”
But the Fed may have also failed to judge the housing market in the context of the broader economy. What the Fed failed to recognize is that while it might be good when housing or stock prices rise sharply just after a major economic slowdown, it is not necessarily good when that happens after the economy has been expanding strongly for an extended period. That is, it was not a threat that home values finally started to jump in 2012, as it allowed the long recovery in the housing market to continue.
But in 2007, those home price gains were occurring after the housing market had reached record levels and the economy had been expanding solidly for an extended period. Then, the price surge represented a level of exuberance and irrational expectations that could not be sustained. The price bubble was a threat that had to be dealt with but wasn’t. The context of price changes matters, and it should have made a difference on how monetary policy was conducted. Unfortunately, it didn’t, and the bubble burst and the Great Recession followed.
– Excerpt from "Big Picture Economics: How to Navigate the New Global Economy" by Joel L. Naroff and Ron Scherer (Wiley, 2014). Copyright (c) 2014 by Joel L. Naroff and Ron Scherer. Reprinted with permission by John Wiley & Sons.