Critics of the US Federal Reserve are having a field day with embarrassing revelations of its risk assessments on the eve of thefinancial 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 crisisdid not erupt until the collapse of Lehman Brothers in September 2008, it wasclear 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 Fedofficials clearly failed to recognize the significance of what was unfolding. One governor opinedthat the Fed should regard it as a good thing that markets were starting toworry about subprime mortgages. Another argued that the summertime marketstress would most likely be a hiccup.
Various critics are seizingon such statements as evidence that the Fed is incompetent, and that itsindependence should be curtailed, or worse. Thisis nonsense. Yes, things could and should have been done better; but to single out Fed governors for missing the comingcatastrophe is ludicrous.
The Fed was hardly alone. In August 2007, few marketparticipants, even those with access to mountains of information and a broadrange of expert opinions, had a real clue as to what was going on. Certainlythe US Congress was clueless; its members werestill busy lobbying for the government-backed housing-mortgage agencies FannieMae and Freddie Mac, thereby digging the holedeeper.
Nor did the International Monetary Fund have a shining moment. In April 2007, the IMF released itsfamous “Valentine’s Day” WorldEconomic Outlook, in which it declared that all of the problemsin the United States and other advanced economies that it had been worryingabout were overblown.
Moreover, it is misleading to single out the most misguided comments by individual governors in thecontext of an active intellectual debate over policy. It is legitimate tocriticize individual policymakers who exercised poor judgment, and they shouldhave a mark on their record. But that does not impugnthe whole FOMC, much less the entire institution.
Central banks’ state-of-the-artmacroeconomic models also failed miserably – to a degree that the economicsprofession has only now begun to acknowledge fully. Although the Fed assessesmany approaches and indicators in making its decisions, there is no doubt thatit was heavily influenced by mainstream academic thinking – including theso-called real business cycle models and New Keynesianmodels – which assumed that financial markets operate flawlessly.Indeed, the economics profession and the world’s major central banks advertisedthe idea of the “great moderation” – the mutingof macroeconomic volatility, owing partly to monetaryauthorities’ supposedly more scientific, model-based approach to policymaking.
We now know that canonicalmacroeconomic models do not adequately allow for financial-market fragilities, and that fixing the models whileretaining their tractability is a formidabletask. Frankly, had the models at least allowed for the possibility ofcredit-market imperfections, the Fed might have paid more attention tocredit-market indicators as a reflection of overall financial-marketconditions, as central banks in emerging-market countries do.
Last but not least, even if the Fed had better understoodthe risks, it would not have been easy for it to avertthe 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, forexample, the Fed and the US Treasury had most likely already seen at least onereport arguing that only massive intervention to support subprime loans could forestall a catastrophe. The idea was to save thefinancial system from having to deal with safely dismantlingthe impossibly complex contractual edifices –which did not allow for the possibility of systemic collapse – that it hadconstructed.
Such a bailout would have cost an estimated $500 billion ormore, and the main beneficiaries would have included big financial firms. Wasthere any realistic chance that such a measure would have passed Congressbefore 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 inSingapore on August 19, 2008, a month before Lehman Brothers failed. I arguedthat things would not get better until they got much worse, and that thecollapse of one of the world’s largest financial firms was imminent. My argument rested on my view that the globaleconomy was entering a major recession, and I had the benefit of myquantitative work, with Carmen Reinhart, on the history of financial crises.
I was not trying to be sensational in Singapore. I thoughtthat what I was saying was completely obvious. Nevertheless, my predictiongained 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 of2008? We will have to wait until next year to find out. But, when we do, let usremember that hindsight is 20-20.