Neil Irwin: 2007 Fed transcripts show how little they understood

In a Washington Post column, Neil Irwin confirms what your humble blogger has been saying since the beginning of the financial crisis, despite how much they "knew", the transcripts from the 2007 Fed meetings and conference calls reveal "how little they understood".

There is a difference between access to data and the ability to transform this data into meaningful information and an appropriate policy response.

I have tried to make the point that the Fed's actions showed it didn't and still doesn't understand what has gone wrong in the financial system in different ways on this blog including

• I have talked about group think and the idea that data was discounted because it didn't fit with the economic models that Fed officials think describe the economy and how it works.
• For example, I cited economist Anna Schwartz, Milton Friedman's co-author, who criticized the Fed for not understanding that the problem was bank solvency and not liquidity.  

• I have talked about Economics 101 and how the necessary condition for the invisible hand to operate properly is that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess this information and make a fully informed decision.  While the Fed officials knew about opacity, their statements showed they didn't understand the implications for
• Predicting the path of the financial crisis.  It moved through all the opaque corners of the financial system from structured finance securities to bank balance sheets.
• Understanding what policy responses would work to end the financial crisis.  

• I have talked about the Blob, Jeff Connaughton's phrase for the combination of politicians, financial regulators, lobbyists and Wall Street, and how the Blob influences policy choices for the benefit of the banks.  
• One aspect of the Blob is the notion of regulatory capture as evidenced by the Fed turning to the banks for advice on how to respond to the financial crisis caused by the banks.

Regardless of why the Fed didn't understand what was and is still happening, the lesson to be learned is that the Fed should not have had then and most definitely should not have going forward a monopoly on all the useful, relevant information in an appropriate, timely manner.

For example, the Fed had information on the exposure details for the large US banks that was not available to other market participants, including the banks.  As a result, when the Fed failed to properly assess what was happening, the Fed couldn't properly convey to the other market participants the risks.

Compounding the failure to properly assess what was happening was the determined effort by the Fed officials in the 2007 transcripts to issue press releases that would not 'scare' the financial markets.

By taking away the Fed's information monopoly and making all the useful, relevant data about banks and structured finance securities available to all market participants in an appropriate, timely manner, market participants can then independently assess the risks and make fully informed investment decisions.

Investment decisions where they know they are responsible for all gains and losses (there are no bailouts for their failure to accurately assess the risk of a bank or security under the FDR Framework principal of caveat emptor (buyer beware) on which our financial system is based).

In making sense of the newly released transcripts from the Federal Reserve’s 2007 policy meetings, let’s get one thing out of the way first. Prediction is hard, as Yogi Berra said, especially when it’s about the future.

Making an accurate prediction is virtually impossible if, like the Fed officials, you don't understand what is happening.

However, if like your humble blogger you do understand what is happening, then making accurate predictions becomes much easier.

That is doubly true when you add in the way things work in financial panics, in which outcomes are highly nonlinear—that’s to say, when one bank or segment of the money markets starts to experience problems, it can rapidly become a domino effect that, as we learned, can spread in unpredictable ways that bring down the entire financial system.

Actually, it spread in a very linear fashion through the opaque corners of the financial system starting with structured finance securities and ending with the 'black box' banks.

But here’s the thing. I really thought we would see more foresight in these transcripts than there is to be found. 

I was covering the Fed at the time for the Post, and subsequently reported and wrote a book that covers the events of 2007 ... 

I had the sense that even as leaders of the central bank projected public calm, and confidence that there would be no recession (let alone the near-depression that in fact materialized), that behind closed doors they saw what direction things were heading. It isn’t so. 

Sure, there were hints of clear-headedness....

It should also be added that there’s not much reason to think the crisis could have been prevented if the Fed had been quicker on the draw. If you honestly believe that we would have skirted recession if the Fed had cut rates by 0.5 percentage points at the December 2007 meeting, not 0.25 percentage points, you have a distorted sense of the power of a central bank to shape the course of the economy.

Actually, the way to have moderated the impact of the financial crisis was to bring transparency to all the opaque corners of the financial system.  Bloomberg quoted me as saying so in December 2007.

Here we are more than five years later and transparency has not been brought to all the opaque corners of the financial system.  As a result, the real economy has and is still experiencing the full impact of the financial crisis.

But I expected to see much more evidence in these transcripts that the Fed officials had a good grasp of how the fissures that were emerging in the summer of 2007 could spiral out of control.

That’s not to say they should have been predicting the gory details of what was to come. It would have been hard to see exactly what path the crisis would take... 

I did expect, though, that Fed officials would show more evidence of understanding the possibility that the entire financial system had become a house of cards built on mortgage securities that were anything but secure, with all sorts of financial institutions over-levered and overly dependent on assets that were near-impossible to value. 

And I expected them to understand that once a problem that deep begins correcting itself, it can spiral into all sorts of dangerous directions. Which this one did.

Please re-read the highlighted text as Mr. Irwin nicely summarizes what you humble blogger has said the problem with the financial system was and still is.

In other words, I hoped that when Fed officials publicly dismissed the chances of a recession as late as the fall of 2007, they were acting like parents who try to keep news of a layoff from their children; that they might be fully aware of how dangerous things were becoming, but didn’t want to scare anyone. 

I was wrong about that. 

Theirs was, at its core, a failure of creativity. It was an inability to see how these moving pieces of an infinitely complex financial system and economy could interact to create a very bad situation.... 

Their failure is much worse.  They failed to understand how our financial system actually works.  They failed to understand that our financial system is based on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor.

The Fed officials were aware of opacity in the financial system, they had no idea what the implications of this opacity were.

One lesson here is that our public officials, even the hard-working, highly intelligent ones, are far from demi-gods. They have the same blind spots and tendency toward analytical failures of anyone else. 

Secrecy allows public officials, whether in the world of monetary policy or others like national security, to create a Wizard of Oz like illusion of holding great power, of maneuvering levers with information in hand that mere mortals can only dream of. 

When reporters interview a high official, there is often a subtext the high official aims to convey: If you knew what I know, you would understand the supreme wisdom of my actions. 

Seeing what the Fed officials were saying privately, to each other, in 2007 is a reminder that this isn’t always so, and just because a person has more information, it doesn’t mean he or she has the right answer.

Thank you Mr. Irwin for making the case for stripping the financial regulators of their information monopoly and restoring transparency to all the opaque corners of the financial system.