Friday, November 28, 2014

Blaming the Fed

FRANKFURT – Critics of the US Federal Reserve are having a field day with embarrassing revelations of its risk assessments on the eve of the financial crisis. By law, the Fed is required to publish the transcripts of its Federal Open Market Committee (FOMC) meetings with a five-year lag.

While the full-blown crisis did not erupt until the collapse of Lehman Brothers in September 2008, it was clear by the summer of 2007 that something was very wrong in credit markets, which were starting to behave in all sorts of strange ways. Yet many Fed officials clearly failed to recognize the significance of what was unfolding. One governor opined that the Fed should regard it as a good thing that markets were starting to worry about subprime mortgages. Another argued that the summertime market stress would most likely be a hiccup.

Various critics are seizing on such statements as evidence that the Fed is incompetent, and that its independence should be curtailed, or worse. This is nonsense. Yes, things could and should have been done better; but to single out Fed governors for missing the coming catastrophe is ludicrous.

The Fed was hardly alone. In August 2007, few market participants, even those with access to mountains of information and a broad range of expert opinions, had a real clue as to what was going on. Certainly the US Congress was clueless; its members were still busy lobbying for the government-backed housing-mortgage agencies Fannie Mae and Freddie Mac, thereby digging the hole deeper.

Nor did the International Monetary Fund have a shining moment. In April 2007, the IMF released its famous “Valentine’s Day” World Economic Outlook, in which it declared that all of the problems in the United States and other advanced economies that it had been worrying about were overblown.

Moreover, it is misleading to single out the most misguided comments by individual governors in the context of an active intellectual debate over policy. It is legitimate to criticize individual policymakers who exercised poor judgment, and they should have a mark on their record. But that does not impugn the whole FOMC, much less the entire institution.

Central banks’ state-of-the-art macroeconomic models also failed miserably – to a degree that the economics profession has only now begun to acknowledge fully. Although the Fed assesses many approaches and indicators in making its decisions, there is no doubt that it was heavily influenced by mainstream academic thinking – including the so-called real business cycle models and New Keynesian models – which assumed that financial markets operate flawlessly. Indeed, the economics profession and the world’s major central banks advertised the idea of the “great moderation” – the muting of macroeconomic volatility, owing partly to monetary authorities’ supposedly more scientific, model-based approach to policymaking.

We now know that canonical macroeconomic models do not adequately allow for financial-market fragilities, and that fixing the models while retaining their tractability is a formidable task. Frankly, had the models at least allowed for the possibility of credit-market imperfections, the Fed might have paid more attention to credit-market indicators as a reflection of overall financial-market conditions, as central banks in emerging-market countries do.

Last but not least, even if the Fed had better understood the risks, it would not have been easy for it to avert the crisis on its own. The effectiveness of interest-rate policy is limited, and many of the deepest problems were on the regulatory side.

And calibrating a response was not easy. By late 2007, for example, the Fed and the US Treasury had most likely already seen at least one report arguing that only massive intervention to support subprime loans could forestall a catastrophe. The idea was to save the financial system from having to deal with safely dismantling the impossibly complex contractual edifices – which did not allow for the possibility of systemic collapse – that it had constructed.

Such a bailout would have cost an estimated $500 billion or more, and the main beneficiaries would have included big financial firms. Was there any realistic chance that such a measure would have passed Congress before there was blood in the streets?

Indeed, it was precisely this logic that me led to give a very dark forecast in a widely covered speech in Singapore on August 19, 2008, a month before Lehman Brothers failed. I argued that things would not get better until they got much worse, and that the collapse of one of the world’s largest financial firms was imminent. My argument rested on my view that the global economy was entering a major recession, and I had the benefit of my quantitative work, with Carmen Reinhart, on the history of financial crises.

I was not trying to be sensational in Singapore. I thought that what I was saying was completely obvious. Nevertheless, my prediction gained bold front-page headlines in many major newspapers throughout the world. It gained headlines, evidently, because it was still far from a consensus view, although concerns were mounting.

Were concerns mounting at the Fed as well in the summer of 2008? We will have to wait until next year to find out. But, when we do, let us remember that hindsight is 20-20.

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    1. CommentedRoman Bleifer

      Situation in February 2013 on the one hand different from that in August 2008, and on the other hand is very similar. It was even worse. Central banks have practically exhausted its possibilities civilized regulate financial markets. Multibillion-dollar infusion like an act of desperation. Neither problem has not been solved by nature over the years. The necessary investments in the real sector of the economy as there was or not. The banking system is weakened. The growth of sovereign debt has significantly undermined the stability of the monetary system. Grew only speculative financial bubbles. Ahead of the inevitable collapse of the stock markets. Only in this way can happen revaluation of assets and a new system of assessment. With the global systemic crisis can not save everyone ( ). We need to develop priorities. The crisis has greatly changed the system of international division of labor.

    2. CommentedG. A. Pakela

      If bank regulators, e.g., Tim Geithner, did what they were supposed to do, banks would have never been permitted to lend money to any institution that uses that leverage to purchase securities to amp up profits. I believe that it was James Grant who asked the rhetorical question as to why a banker who gets 5% for a loan should lend money to a hedge find (like Long Term Capital Management) that is heavily levered so that it can earn spectacular double digit returns.

      Anyone with average intelligence can take on borrowing risk, particularly of the cost of failure is not commensurate with the potential returns - that would be all of those who borrowed at zero percent down and walked away from their mortgages. There is no difference between the public that took advantage of the low down payment, docless terms and the Dick Fulds, Stan O'Neals and Chuck Princes of the world that leveraged their companies into disaster, except that the latter walked away with a heck of lot more money.

      As for Dr. Rogoff's contention that financial recessions last a lot longer than ordinary recessions, it has been about three decades since the public started taking on increasing debt and borrowing against their assets to finance consumption. Eventually it had to end, but no one could predict precisely when that would happen. There is no new impetus for increased consumer demand until the supply-side of the economy starts to rev itself up and begins hiring back all of the unemployed labor that is waiting for the opportunity.

    3. CommentedFrank O'Callaghan

      All of those who were in a position of power or influence were immune from negative consequences. The poor and the middle class are paying for this mess.
      This whole system is based on inequality. It cannot be expected that such a system will act in the interests of those who have no say in it's direction.

    4. Portrait of Pingfan Hong

      CommentedPingfan Hong

      We should not blame individual Fed governors for failing to foresee the coming crisis in 2007, but we should blame the Fed as the institution for fueling the bubbles in the run up to the crisis.

    5. CommentedGeoff Robinson

      "Central banks’ state-of-the-art macroeconomic models also failed miserably"

      The problem with the Fed isn't that we know more in hindsight, which we do. It's the fatal conceit. It's not that they are incompetent, but centrally planning the price of money is impossible. It's just not possible. It causes all sorts of distortions. Not being able to see a bubble right about the burst should destroy all illusions that they can manage the economy. While failing at an impossible task is not blameworthy, not being able to see that the Fed faces an impossible task, especially in 2013, is blameworthy.

    6. Portrait of Pingfan Hong

      CommentedPingfan Hong

      Only two kinds of people have correctly predicted the financial crisis in terms of its timing and severity: perennial pessimists, and speculators, by chance.

        CommentedGeoff Robinson

        In this amount of detail they predicted the crash?

    7. Commentedjim bridgeman

      The issue seems to be whether the Fed is a financial institution or an economic one. If the former, then they were certainly a good deal less competent than the most advanced financial institutions. By Dec. 2006 Goldman's corporate risk managers knew that the credit markets were going to implode and by early 2007 they were actively hedging and unwinding their proprietary positions. But if the Fed is an economic (which is to say, political) institution then it can't be held to account for a failure to know what's going on in the technical financial world.

    8. Commentedarnim holzer

      I appreciate professor Rogoff's analysis and agree that hindsight always adds IQ points and clairvoyance. The most important point, however, is that our system of modified moral hazard created asymmetry in the risk / reward relationship for financial institutions at a size most investors and regulators simply did not understand. While leverage statistics and credit data were available, the degree of fraud and poor control was simply overlooked because the burden of risk was not equitably distributed. This philisophical misallocation of risk that Nassim Taleb discusses in 'Antifragile' is part of the Fed's purview and hopefully will be better understood in the future. Regulation can be dangerous but ultimately the penalty for inequitable risk/ reward is costly bail-outs. The Fed's transcripts are indeed interesting and document a snapshot applicable to a brutal moment in our financial history. I would hope that the next releases also give us insight into the Fed's deeper thought process about risk and reward and the correct balance of free financial markets and societal protection. As always, there has been a political backlash from capital hill to establish extreme measures to avoid the risk of another financial meltdown. What is most needed, however, is not sure to be anachronistic new rules but fundamental principals and thoughts that correctly weigh risks and reward for the benefit of the economy and society.

    9. Commentedlaurie gravelines

      Hindsight is never 20-20; it is revisionist-memory. Errors are diminished, insights embellished. Learning the lessons of our past remains a challenge - our hindsight still passes through the prism of our pre-conceptions and intellectual architecture. Our ability to learn lessons from our past should never be taken for granted and the danger of learning the wrong lessons should not be unheeded.

    10. CommentedAlan Marin

      As an example of how even excellent economists can get assessments wrong, Professor Rogoff could have mentioned that The Times account of his August 2008 speech included the paragraph:
      "The professor also sounded a warning over rising US inflation, which rose last month to its highest since
      1991, and criticised the Federal Reserve for having cut American interest rates too drastically. “Cutting
      interest rates is going to lead to a lot of inflation in the next few years in the United States,” he said."
      Given the lags in the effects of interest rates on output and then inflation, in retrospect the 'drastic' cut in US interest rates turned out to be a much better policy than the delayed response by other central banks.