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An economist recently recommended that I read a paper by three Fed researchers titled: “Why Did So Many People Make So Many Ex Post Bad Decisions? The Causes of the Foreclosure Crisis.” It was presented at a major conference last year and made the rounds again in the economics blogosphere this year with generally positive reviews. It seems to have been influential.
The authors – Christopher Foote, Kristopher Gerardi and Paul Willen – argue that the financial crisis was caused by over-optimistic expectations for house prices, while other factors such as distorted incentives for bankers played only minor roles or no roles at all. In other words, it was a bubble just like the Dutch tulip mania of the 1630s or South Sea bubble of the early 1700s, and had nothing to do with modern financial practices.
Then the authors make absolutely sure of their work being well-received by those who matter. The financial crisis is surely a touchy subject at the Fed, where the biggest PR challenge is “bubble blowing” criticism from those of us who aren’t on the payroll (directly or indirectly). But Foote, Gerardi and Willen are, of course, on the payroll. They tell us there’s little else that can be said about the origins of the crisis, because any “honest economist” will admit to not understanding bubbles.
Here’s their story:
[I]t is deeply unsatisfying to explain the bad decisions of both borrowers and lenders with a bubble without explaining how the bubble arose. …Unfortunately, the study of bubbles is too young to provide much guidance on this point. For now, we have no choice but to plead ignorance, and we believe that all honest economists should do the same. But acknowledging what we don’t know should not blind us to what we do know: the bursting of a massive and unsustainable housing bubble in the U.S. housing market caused the financial crisis.
We don’t often critique papers like this (who cares about Fed research outside of academic economists?) But what the heck, the bolded sentences above – in particular, the hypocritical reference to “honest economists” – deserve at least a few words of rebuttal.
We’ll limit our comments to two areas. First, we’ll offer a redline edited version of a key section in the authors’ conclusion, mostly to share a different perspective on the financial crisis. Second, we’ll point out an example of dishonesty from these economists who brazenly claim that their own perspective is the only one that can be called honest.
Where did the bubble come from?
In practice, the authors don’t completely “plead ignorance” about the causes of bubbles as they claim to do. They offer a few “speculative” ideas about the housing bubble, writing:
One speculative story begins with the idea that some fundamental determinants of housing prices caused them to move higher early in the boom. Perhaps the accommodative monetary policy used to fight the 2001 recession, or higher savings rates among developing countries, pushed U.S. interest rates lower and thereby pushed U.S. housing prices higher. Additionally, after the steep stock market decline of the early 2000s, U.S. investors may have been attracted to real estate because it appeared to offer less risk. The decisions of Fannie Mae and Freddie Mac may have also played a role in supporting higher prices…
This smells to us like a strategy of gently acknowledging criticism (of the Fed’s interest rate policies), while at the same time attempting to neutralize it. The authors imply that low interest rates were an unavoidable byproduct of the Fed’s recession fighting, and then shift some of the blame to foreigners in developing countries before moving on to other possible explanations.
But even if you believe the Fed’s anti-recession measures were worthwhile, the authors’ story is nonsense. It needs corrections for the facts that the Fed continued to slash rates nearly two years after the 2001 recession and then maintained an ultra-easy stance for a few years after that. It also begs the question of why the Fed responded to high foreign savings rates – which were the flip side to U.S. current account deficits and primary source of disinflation – with even greater stimulus. Moreover, there’s much more to the Fed’s role in the housing boom than these factors.
As we see it, the financial crisis validated certain principles that aren’t reflected in mainstream models but feature in fringe areas such as Austrian business cycle theory orbehavioral economics. Economists in these areas offer far more detailed explanations for the housing bubble than the “speculative story” above. For example, recent Nobel Prize winner Robert Shiller filled a whole book with bubble theories. While Foote, Gerardi and Willen would presumably call these economists dishonest, we beg to differ. Borrowing from non-mainstream ideas, here’s our edited version of the excerpt:
If this version is accurate, the Fed’s failures include three whoppers:
- Monetary policy was too stimulative throughout the boom.
- Two decades of Greenspan/Bernanke “puts” created a mentality that risky bets couldn’t lose (moral hazard).
- The Fed applauded rather than stopping the deterioration in lending standards, blithely disregarding its status as only institution that was mandated to set nation-wide lending requirements.
As you might expect, Foote, Girardi and Willen weave a story that either denies or diverts attention from all three failures. One part of the story is their claim that bubbles can’t be explained and anyone who thinks otherwise is dishonest. If the defining feature of the crisis can’t be explained, then it can’t be blamed on the Fed, right?
Other parts of the story are embedded in 12 “facts” that are said to describe the crisis. As written, many of the “facts” are strictly true. Some may have even added to the public debate because they weren’t widely known in policy circles, even as they were understood in the fixed income business. Others, though, can only distort that debate. The worst of the so-called facts are somewhere in between flat wrong and technically accurate but interpreted in ways that don’t stand up to scrutiny.
Lending standards didn’t really change during the boom?!?
We’ll point out a single example, from pages 9-11 of the paper and sub-titled, “Fact 4: Government policy toward the mortgage market did not change much from 1990 to 2005.” In this section, the authors deny that policymakers dropped the ball on lending standards. They don’t mention central bankers explicitly (that would be too obvious?), choosing instead to absolve the Clinton administration of blame for its ill-fated National Home Ownership strategy. Of course, their argument also exonerates the Fed if you happen to believe it.
The argument depends partly on a history lesson that begins like this:
It is true that large downpayments were once required to purchase homes in the United States. It is also true that the federal government was instrumental in reducing required downpayments in an effort to expand homeownership. The problem for the bad government theory is that the timing of government involvement is almost exactly 50 years off. The key event was the Servicemen’s Readjustment Act of 1944, better known as the GI Bill, in which the federal government promised to take a first-loss position equal to 50 percent of the mortgage balance, up to $2,000, on mortgages originated to returning veterans.
The authors then tell a nostalgic tale about loan-to-value (LTV) ratios in the 1950s and 1960s, before skipping ahead to the 1990s and 2000s. For the latter period, we’re told to believe that lending standards didn’t decline in a meaningful way:
Figure 6 shows LTV ratios for purchase mortgages in Massachusetts from 1990 to 2010, the period when government intervention is supposed to have caused so much trouble … But inspection of Figure 6 does not support the assertion that underwriting behavior was significantly changed by that program [Clinton’s National Homeownership Strategy].
Here’s the key chart that goes with this claim:
Here are a few reasons why the thesis doesn’t fit the reality:
- The authors share data for only one state (Massachusetts), while failing to mention that it didn’t have much of a housing bust. Consider that Boston is one of only four cities (out of 20) in the S&P/Case-Shiller Home Price Index for which prices didn’t fall by more than 20%. During the bear market period for the full index, the Boston component fell only 16%, less than half the 34% drop in the national index.
- The authors’ sweeping argument relies on not only a single state, but also a single indicator (LTV ratios). You might wonder: What were the credit scores of borrowers at each LTV level? How did their incomes compare to monthly mortgage payments? Were their incomes verified? These types of questions need answers before you can draw general conclusions about underwriting behavior.
- Even the cherry-picked data – Massachusetts LTV ratios! – doesn’t support the authors’ conclusions. It shows that the incidence of ratios greater than 100% tripled during the housing boom, from about 8% of all Massachusetts mortgages to about 25%. The claim that this change isn’t significant is incredulous.
- LTV ratios in the 1950s and 1960s, while interesting, are irrelevant to the early 21stcentury housing boom. Different era, different circumstances, different implications.
Needless to say, the authors’ attempt at defending fellow public officials falls well short. Lending standards declined sharply during the boom, and this was encouraged by both the federal government and the Fed. No amount of data mining can change these facts.
Overall, the Fed staffers’ paper fits a common pattern. It’s stuffed with enough data to be taken seriously, but inferences are based more on spin than objective analysis. The approach aligns conclusions with an establishment narrative, while protecting the authors’ establishment status. The last thing you would call this paper is an honest piece of research.
As long as we’re at it, here’s an extra edit, this one offering another perspective on Foote, Gerardi and Willen’s conclusions about our knowledge of bubbles (from the first excerpt above):
If You Don’t Trust the Fed, Here’s an Inside View That Confirms Your Worst Suspicions | CYNICONOMICS
If You Don’t Trust the Fed, Here’s an Inside View That Confirms Your Worst Suspicions
Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.
– Former FOMC Governor Kevin Warsh, writing in the Wall Street Journal on November 13.
If I may paraphrase a sainted figure for many of my colleagues, John Maynard Keynes: If the members of the FOMC could manage to get themselves to once again be thought of as humble, competent people on the level of dentists, that would be splendid. I would argue that the time to reassume a more humble central banker persona is upon us.
– Dallas Fed President Richard Fisher, speaking in Chicago on December 9.
I fault the Fed for its lack of intellectual leadership on the economy and, in particular, Bernanke’s lack of forthrightness about the limits of the Fed’s ability to address slow growth and fiscal disequilibrium.
– Former St. Louis Fed President William Poole, speaking in Washington D.C. on March 7.
Does anyone else see a common theme?
Last month, we offered a plain language translation of the Warsh op-ed, because we thought it was too carefully worded and left readers wondering what he really wanted to say. Translation wasn’t necessary for Fisher’s speech, which contained a clear no-confidence vote in the Fed’s QE program. Poole’s comment was from a seminar question-and-answer session earlier this year, but it reached our inbox only last week in a transcript published in the latest Financial Analysts Journal. The Q&A was attached to an article that I’ll discuss here, because it makes claims we haven’t heard from others with FOMC experience.
Here’s an example:
Ben Bernanke talks a lot about risk management and the tradeoff between benefits and costs; he maintains that the need to balance these two issues justifies proceeding with the current policy. But Bernanke does not discuss the risk of political intervention in Fed policy despite numerous examples of the Fed giving in to political pressure and waiting too long to change its policy, which results in a detrimental outcome for the economy.
Essentially, pressure on the Fed will come from inside the government and may not be very visible; it may be limited to a few op-ed articles from the housing lobby. [FFW – presumably, Poole intended “it” to refer to the visible part of the pressure.] The true amount of political pressure will be largely hidden.
Poole is more or less saying that we have no idea what’s truly behind the Fed’s decisions. But he doesn’t stop there. He’s willing to make a prediction that you wouldn’t expect from an establishment economist:
[T]he real issue is the politics of monetary policy … I believe that the Fed will not successfully resist the political winds that buffet it. I am not a political expert or a political analyst by trade. My qualification for speaking on this topic is that I have followed the interactions between monetary policy and politics for a very long time. As with all things political, the politics of the Fed means that realities often fail to match outward appearances … I believe the Fed is likely to overdo its current QE policy of purchasing $45 billion of Treasuries and $40 billion of MBSs per month.
So there you have it: a 10-year FOMC veteran wants us to know that central banking isn’t all about the latest hot research on the wonders of unconventional measures. On the contrary, monetary policy is no different than other types of policymaking; it’s guided by hidden political forces.
If you don’t mind our saying so, we feel a bit vindicated. Our very first Fed post ten months ago included the following:
As for the flip-flop [the Fed’s commitment to lifting the stock market through QE so shortly after claiming no responsibility for stock prices in recent bubbles], it’s easy to find a logical explanation. The banks want QE. Influential political and economic leaders want QE. Therefore, the path of least resistance is to give them QE. On the other hand, market manipulation to prick the Internet and housing bubbles would have been widely unpopular. Therefore, policymakers rejected the idea that they should manipulate markets and prick bubbles. No one likes to be unpopular.
More generally, QE seems to me to be explained by Bernanke (and his colleagues) being unable to sit still. This is natural behavior when you have to continually justify decisions. It’s not easy to explain to Congress, the media or public why you’re doing nothing but waiting for past policies to work. It won’t be long before people portray you as weak and indecisive and tell you to “Get to work, Mr. Chairman.” But once you start implementing new policies, especially if they’re in a direction that’s expedient for everyone in the short-term, then those criticisms go away. They’re replaced by adjectives like bold and proactive. And who doesn’t want to be known as bold and proactive?
We haven’t returned to this theme often, partly because it can’t be tested like we can test the Fed’s economic beliefs. Regular readers know that we do quite a lot of empirical work. We try our best to follow David Hume’s maxim that: “A wise man, therefore, proportions his belief to the evidence.”
As we see it, the Fed’s economic beliefs are proportioned more closely to political factors than real-life evidence. You might replace Hume with Upton Sinclair, who said “it is difficult to get a man to understand something when his salary depends on him not understanding it.”
In other words, politics and personal incentives are a huge part of the picture, and not just in central banking but in the economics profession more generally.
The theories underpinning current policies, which have built up over the last 80 years or so, can’t be properly understood without thinking through the motivations behind key developments. Some of the motivational factors are obvious, while others are more subtle, but I won’t clutter this post with our musings on the hidden drivers in economics. Detlev Schlichter offered a nice summary in his book, Paper Money Collapse:
It would be naïve to simply assume that the exalted position of [mainstream economic] theories in present debate is the result of their superiority in the realm of pure sciences. This is not meant as a conspiracy theory in the sense that professional economists are being hired specifically to develop useful theories for the privileged money producers in order to portray their money printing as universally beneficial. But it would be equally wrong to assume that the battle for ideas is fought only by dispassionate and objective truth-seekers in ivory towers and that only the best theories are handed down to the decision makers in the real world, and that therefore whatever forms the basis of current mainstream discussion must be the best and most accurate theory available. No science operates in a vacuum. The social sciences in particular are often influenced in terms of their focus and method of inquiry by larger cultural and intellectual trends in society. This is probably more readily accepted in the other major social science, history. What questions research asks of the historical record, what areas of inquiry are deemed most pressing and how historians go about historical analysis is often shaped by factors that lie outside the field of science proper and that reflect broader social and political forces.
Moreover, ever since mankind began writing its histories they have served political ends. History frequently provides a narrative for the polity that gives it a sense of identity or purpose, whether this is justified or not, and the dominant interpretations of history can be powerful influences on present politics. Similarly, certain economic theories have become to dominate debate on economic issues because they fit the zeitgeist and specific political ideologies. This is not to say that economics cannot be a pure, objective science. It certainly can and should be. Whether theories are correct or not must be decided by scientific inquiry and debate, and not in the arena of politics and public opinion. But it is certainly true that many economists do depend for their livelihoods on politics and public opinion, and that they cannot operate independently of them.
Schlichter is one of many authors and bloggers willing to discuss the awkward realities lurking behind economic theory and central banking. But these ideas are considered taboo by most mainstream media outlets. They’re not discussed in establishment venues or spoken by establishment figures.
Or so I thought.
Poole’s refreshingly honest take on the Fed’s inner workings – from someone who truly knows what goes on behind the curtains – is more than welcome.
Hunting season is off to a good start this week, and I’m not just talking about deer hunting. It seems that former Fed officials declared open season on their ex-colleagues.
First, Andrew Huszar, who once ran the Fed’s mortgage buying operation, let loose in yesterday’s Wall Street Journal. Huszar apologized to all Americans for his role in the toxic QE programs.
And then today, the WSJ struck again, this time with an op-ed by former FOMC Governor Kevin Warsh.
Instead of excerpting the Huszar essay, we’ll only share the apt words of commenter Ernest Moosa, who wrote:
Every reader needs to understand and grasp what is being said here. We have been on the wrong economic path for five years, and without the desired results, our leadership says “FULL SPEED AHEAD”. We have wasted so much time and money that future generations will point to us and say this is how a great country can be destroyed in less than a decade with no shots even being fired. Deplorable.
Moosa hit the nail on the head, and we recommend reading the op-ed in its entirety if you haven’t already done so.
As for Warsh’s editorial, it was tough to read without wondering what he’s thinking. Warsh is a former Morgan Stanley investment banker whose 2006 to 2011 stint on the FOMC spanned the end of the housing boom and the first few years of “unconventional” policy measures. After such a solid grounding in the ways of the Fed and Wall Street, he recently morphed into a critic of the status quo. His criticisms are welcome and we believe accurate, but they’re also oh so carefully expressed. They’re written with the polite wording and between-the-lines meanings that you might expect from such an establishment figure. He seems to be holding back.
So, what does he really want to say?
Here are our guesses, alongside excerpts from the editorial on each of nine topics that Warsh covered:
“The purchase of long-term assets from the U.S. Treasury to achieve negative real interest rates is extraordinary, an unprecedented change in practice since the Treasury-Fed Accord of 1951.
The Fed is directly influencing the price of long-term Treasurys—the most important asset in the world, the predicate from which virtually all investment decisions are judged. Earlier this year the notion that the Fed might modestly taper its purchases drove significant upheaval across financial markets. This episode should engender humility on all sides. It should also correct the misimpression that QE is anything other than an untested, incomplete experiment.”
What he really wants to say:
We’d all be better off if the central banking gods (myself included) hadn’t been so damn arrogant to think that we actually understood QE. We don’t, and it never should have been attempted.
The Fed’s focus on inflation
“Low measured inflation and anchored inflationary expectations should only begin the discussion about the wisdom of Fed policy, not least because of the long and variable lags between monetary interventions and their effects on the economy. The most pronounced risk of QE is not an outbreak of hyperinflation. Rather, long periods of free money and subsidized credit are associated with significant capital misallocation and malinvestment—which do not augur well for long-term growth or financial stability.”
What he really wants to say:
The inflation target is stupid. It’s not the CPI that’s killing us, it’s the credit booms and busts. The best way out of this mess is to lose the inflation target and go back to the old-fashioned approach of “taking the punch bowl away when the party gets going.”
Pulling off the exit from extraordinary measures
“[T]he foremost attributes needed by the Fed to end its extraordinary interventions and, ultimately, to raise interest rates, are courage and conviction. The Fed has been roundly criticized for providing candy to spur markets higher. Consider the challenge when a steady diet of spinach is on offer.”
What he really wants to say:
Pundits who praise the courage of our central bankers are clueless. The true story is that we consistently take the easy way out. If the current cast of characters wanted to show courage, they’d man up and replace the short-term sugar highs with long-term thinking.
The Fed’s relationship to the rest of Washington
“The administration and Congress are unwilling or unable to agree on tax and spending priorities, or long-term structural reforms. They avoid making tough choices, confident the Fed’s asset purchases will ride to the rescue. In short, the central bank has become the default provider of aggregate demand. But the more the Fed acts, the more it allows elected representatives to stay on the sidelines. The Fed’s weak tea crowds out stronger policy measures that can only be taken by elected officials. Nobel laureate economist Tom Sargent has it right: ‘Monetary policy cannot be coherent unless fiscal policy is.’”
What he really wants to say:
And if we don’t man up, you can count on Congress to continue with its egregious generational theft and destroy our nation’s finances, just as me, Stan and Geoff have been warning.
Who benefits from QE and who doesn’t?
“Most do not question the Fed’s good intentions, but its policies have winners and losers, which should be acknowledged forthrightly.
The Fed buys mortgage-backed securities, thereby providing a direct boost to balance sheet wealth of existing homeowners to the detriment of renters and prospective future homeowners. The Fed buys long-term Treasurys to suppress yields and push investors into riskier assets, thereby boosting U.S. stocks.
The immediate beneficiaries: well-to-do households and established firms with larger balance sheets, larger risk appetites, and access to low-cost credit. The benefits to workers and retirees with significant fixed obligations are far more attenuated. The plodding improvement in the labor markets offers little solace.”
What he really wants to say:
Unbelievably, my ex-colleagues still don’t acknowledge their policies are killing the middle class to the benefit of the plutocracy. Their silence on this is wholly unacceptable and has to stop (and so do the policies).
Domestic versus global policy considerations
“[T]he U.S. is the linchpin of an integrated global economy. Fed-induced liquidity spreads to the rest of the world through trade and banking channels, capital and investment flows, and financial-market arbitrage. Aggressive easing by the Fed can be contagious, inclining other central banks to ease as well to stay competitive. The privilege of having the dollar as the world’s reserve currency demands a broad view of global economic and financial-market developments. Otherwise, this privilege could be squandered.”
What he really wants to say:
We really need to climb out of our shell and look at things from a global perspective. The rest of the world knows that we’re selling a bill of goods and won’t continue buying it forever. If we don’t change, you can say goodbye to the dollar.
“Since QE began, Fed policy makers have tried to explain that asset purchases and interest rates are different. Hence their refrain that tapering is not tightening, and that very low interest rates will continue after QE. Investors do not agree. Once the Fed begins to wind down its asset purchases, these market participants are likely to reassert their views with considerable force.
Recently, the Fed has elevated forward guidance as a means of persuading investors that it will indeed keep interest rates exceptionally low even after QE. Forward guidance is intended to explain how the central bank will react to incoming data. Fed projections for example, may show below-target inflation and a residual output gap justifying very low interest rates several years from now. But words are not equal to concrete policy action. And the Fed hasn’t received many awards for prescience in recent years.”
What he really wants to say:
Forward guidance is a load of crap. First, you won’t convince the market of any of your dumb ideas. Investors can and will think for themselves. Second, talk is cheap. And talk that’s based on the Fed’s ability to foresee the future? C’mon now, that’s ridiculous.
“[T]ransparency in communications about future policy is not a virtue unto itself. The highest virtue is getting policy right. Given manifest uncertainties about the state of the economy, oversharing policy deliberations is not useful if markets are led astray, or if public commitments reduce policy makers’ flexibility to call things the way they see them.”
What he really wants to say:
Transparency, shmansparency. I’ve had it up to here with taper, untaper, maybe taper, maybe not taper. I’ll trade a transparent central bank for one that knows what it’s doing any day.
Obama’s nomination of Janet Yellen as the next FOMC chair
“The president has nominated a person with a well-deserved reputation for probity and good judgment. The period ahead will demand these qualities in no small measure.”
What he really wants to say:
The president made a bad choice.
These are only our guesses, not actual thoughts from Kevin Warsh, who hasn’t told us what he really wants to say. We don’t even know if he hunts. (We’re guessing no.