I think that Ben Bernanke and the Federal Reserve generally have done a pretty good job managing the fallout from the financial crisis in 2008.
But — despite ample warnings from credible analysts for a period of years — Greenspan and the Fed simply whiffed on the housing bubble even as it was inflating dramatically.
Such overconfidence sounds awfully similar to that of small time investors who threw money away on doomed projects. But those investors were taking cues from their lenders, who were taking cues from the Fed, etc., etc.
All those smart people couldn’t be wrong, could they?
Of course, as it turns out, those smart people were very wrong, and today’s release of Fed notes from 2006 gives us a glimpse at the hubris. Again, let me note that by the time these notes were being taken, there were plenty of analysts warning of a possible financial crisis and clearly stating why a collapsing housing market would drag down the rest of the economy.
From Greenspan image tarnished by newly released documents in the Washington Post:
The Thursday release of transcripts of Fed meetings in 2006 shows that top leaders of the Fed — several of whom continue to hold key positions today — had a limited awareness of the gravity of the threat that the weakness in the housing market posed to the rest of the economy. And they had what turned out to be an excessive optimism about how well things would turn out.
In his first meeting as Fed chairman, Ben S. Bernanke noted that the housing market was causing some uncertainty, but that he “was reassured to hear that most participants think that a decline in housing will be cushioned by strong fundamentals in terms of income, jobs, and continuing low interest rates.”
He agreed with that view, saying “strong fundamentals support a relatively soft landing in housing.” He pointed out that residential investment represents just 6 percent of the economy. “I think it would take a very strong decline in the housing market to substantially derail the strong momentum for growth that we are currently seeing in the economy.”
The year 2006 started out with adulation all around for Greenspan. Roger Ferguson, the Fed vice chair and current head of TIAA-CREF, called him a “monetary policy Yoda.”
Janet Yellen, then president of the Federal Reserve Bank of San Francisco and now vice chair of the Fed, told Greenspan “that the situation you’re handing off to your successor is a lot like a tennis racquet with a gigantic sweet spot.”
Throughout the year, the Fed was slow to realize what was happening in the housing market and the threats it posed, as borrowers who took on risky subprime loans defaulted, causing foreclosures.
A Fed economist reported in a 2006 meeting that “we have not seen — and don’t expect — a broad deterioration in mortgage credit quality.” That turned out to be incorrect.