Revisiting the Fed’s Crisis

BERKELEY – Reading through the just-released transcripts of the US Federal Reserve’s Federal Open Market Committee meetings in 2008, I found myself asking the same overarching question: What accounted for the FOMC’s blinkered mindset as crisis erupted all around it?

To be sure, some understood the true nature of the situation. As Jon Hilsenrath of the Wall Street Journal points out, William Dudley, then the executive vice president of the New York Fed’s Markets Group, presented staff research that sought, politely and compellingly, to turn the principals’ attention to where it needed to be focused. And FOMC members Janet Yellen, Donald Kohn, Eric Rosengren, and Frederic Mishkin, along with the Board of Governors in Washington clearly got the message. But the FOMC’s other eight members, and the rest of the senior staff? Not so much (albeit to greatly varying degrees).

As I read the transcripts, I recalled the long history dating back to 1825, and before, in which the uncontrolled failure of major banks triggered panic, a flight to quality, the collapse of asset prices, and depression. But there in the FOMC’s mid-September 2008 report, many members express self-congratulation for having found the strength to take the incomprehensible decision not to bail out Lehman Brothers.

I find myself thinking back to the winter of 2008, when I stole – and used as much as possible – an observation by the economist Larry Summers. In the aftermath of the housing bubble’s collapse and extraordinary losses in the derivatives market, Summers noted, banks would have to diminish leverage. While it would not matter much to any individual bank whether it did so by reducing its loan portfolio or by raising its capital, it mattered very much to the economy that the banks chose the second.