Saturday, November 26, 2011

Regulators as source of financial instability: the failure to forecast the Great Recession

The Federal Reserve Bank of New York published an interesting post on the failure of economic forecasts since 2007.

At its heart is the idea that no one predicted the Great Recession and therefore that the failure of the Federal Reserve System to do so was excusable.

The idea that no one predicted the Great Recession is not true.  The idea that no one has accurately predicted what has happened since the beginning of the Great Recession is also not true.

One of the reasons my blog attracts readers is that I have predicted both.

Prior to the beginning of the Great Recession, I observed that if opacity in the financial system was not addressed, we would have a crisis.  Once the crisis began, I added the observation that we would continue in a downward spiral with no logical stopping point until opacity in the financial system was addressed.

Unfortunately (I say unfortunately because of the suffering that occurred to everyone outside of Wall Street/Washington), these two predictions have turned out to be very accurate.

In his post, Simon Potter does try to qualify who he includes in the group that failed to predict the Great Recession and its aftermath.  He observes that the economics profession failed - which by definition includes everyone with a PhD currently working in the Federal Reserve System.

A casual observer might conclude if they failed, we should immediately remove anyone who is a trained economist from a position where they can have any impact on the economy... say beginning with the chairman of the Federal Reserve.

Having worked for the Federal Reserve in DC in the area responsible for the analysis supporting monetary policy, I do not think this is the right solution.

Consistent with this blog's focus on disclosure, the right solution is that the Fed should be turned into the single most transparent financial market participant.

Everything the Fed does should be subject to disclosure.

This should apply to everything from the individual bank examination reports to every financial transaction involving the Fed up to and including telecasting the FOMC meetings as they are happening.

You simply cannot root out opacity in the financial system if you let a major financial institution regulator, the lender of last resort and the monetary authority operate in an opaque environment.
Looking through our briefing materials and other sources such as New York Fed staff reports reveals that the Bank’s economic research staff, like most other economists, were behind the curve as the financial crisis developed, even though many of our economists made important contributions to the understanding of the crisis. Three main failures in our real-time forecasting stand out: 
  1. Misunderstanding of the housing boom. Staff analysis of the increase in house prices did not find convincing evidence of overvaluation (see, for example, McCarthy and Peach [2004] and Himmelberg, Mayer, and Sinai [2005]). Thus, we downplayed the risk of a substantial fall in house prices. A robust approach would have put the bar much lower than convincing evidence.
  2. A lack of analysis of the rapid growth of new forms of mortgage finance. Here the reliance on the assumption of efficient markets appears to have dulled our awareness of many of the risks building in financial markets in 2005-07. However, a March 2008 New York Fed staff reportby Ashcraft and Schuermann provided a detailed analysis of how incentives were misaligned throughout the securitization process of subprime mortgages—meaning that the market was not functioning efficiently.
  3. Insufficient weight given to the powerful adverse feedback loops between the financial system and the real economy. Despite a good understanding of the risk of a financial crisis from mid-2007 onward, we were unable to fully connect the dots to real activity until 2008. Eventually, by building on the insights of Adrian and Shin (2008), we gained a better grasp of the power of these feedback loops.
However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants: 
Longer stretches of economic growth imply greater leverage and complacency and thus, greater financial problems when recessions do occur.
--William Dudley and Edward McKelvey3

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