The Weekend Economists' Panglossian Pandemic January 20-22, 2012

[Demeter]

16. Alan Greenspan's ship of fools DEAN BAKER

http://www.guardian.co.uk/commentisfree/cifamerica/2012/jan/18/alan-greenspan-ship-of-fools

The Fed's FOMC is supposed to steer the US economy to prosperity. As we now see, it was completely rudderless in 2006

...But there is more than obsequiousness on display here. There is also profound ignorance of the economy among the nation's top economic policymakers. Keep in mind: 2006 is the year that the $8tn housing bubble hit its peak and began to deflate. In other words, this covers the period in which the Titanic hit the iceberg and began to take on water. But no one on this sinking ship is even thinking about the lifeboats. There is no one in the eight FOMC meetings who suggests that the economy faces any serious turbulence ahead. There is not even discussion that a mild recession could be in sight. In fact, at the last meeting of 2006 (pdf), we hear Janet Yellen, who was then the president of the San Francisco Bank and is now vice-chair of the board of governors, comment that:

"There are some encouraging signs that the demand for housing may be stabilizing … After a precipitous fall, home sales appear to have leveled off … Finally, the gap between housing prices and fundamentals might not be as large as some calculations suggest."

Needless to say, this wasn't quite right. Monthly home sales fell by almost 40% over the course of 2007. House prices, which were just edging downward month to month up to that point, would begin to decline far more rapidly. By the end of 2007, there were falling at a rate of almost 2% a month. In addition to the direct impact that this sort of price decline had on the housing sector, it also implied a loss of almost $400bn a month in housing equity. It was inevitable that a loss of wealth of this magnitude would slow consumption. The FOMC seemed utterly oblivious to the fact that the savings rate had been driven to record lows by the wealth generated by the housing bubble; and that this consumption boom would end when the housing bubble wealth disappeared. People who no longer had equity in their homes could not borrow to support their consumption. Furthermore, those who had expected that home equity would support them in retirement would soon discover that they had to cut back in a big way on consumption in order to rebuild their savings.

It also should have been obvious that a serious wave of defaults was going to hit the financial system. Housing is always a highly leveraged asset, but that was far more true in 2006 than at any prior point in history, as many people were buying homes putting literally nothing down. With prices plunging, millions of homeowners would fall under water. This guaranteed more foreclosures and higher losses on each one. It may not have been obvious who was going to take the hits, but economists who could see the world with clear eyes knew that big hits were coming. Unfortunately, none of them was sitting on the FOMC.

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The public may be powerless at the moment to force our political leaders to take the steps necessary to bring the economy back to full employment. However, we certainly have the ability to ridicule the incompetence of those responsible for this preventable disaster. We should take full advantage of the opportunity provided by the latest Fed transcripts. This might not provide the same respite for a scared and suffering nation as movies did in the Great Depression, but it's a start.