In defending Fed, Ken Rogoff shows that the economics profession has nothing to offer for predicting or handling a financial crisis

In his column in the Guardian, Harvard Professor Ken Rogoff defends the Fed's inability to predict our current financial crisis and admits in discussing his own pre-Lehman speech that the economics profession has nothing to offer when it comes to preventing or predicting a financial crisis.

Regular readers know that this admission is not surprising given that this requires an understanding of how to apply transparency in the real world and not just assume that it will magically come into existence.

Transparency is the necessary condition for the invisible hand to operate properly.  Transparency is also  built into the FDR Framework on which our financial system is based.

Critics of the US Federal Reserve are having a field day with embarrassing revelations of its risk assessments on the eve of the financial crisis.... 

While the full-blown crisis did not erupt until the collapse of Lehman Brothers in September 2008, it was clear 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 Fed officials clearly failed to recognise the significance of what was unfolding.... 

Various critics are seizing on such statements as evidence that the Fed is incompetent, and that its independence should be curtailed, or worse. This is nonsense. ... 

The Fed was hardly alone.

This is not an excuse.  The Fed was one of several financial regulators with a responsibility for understanding what was happening and preventing another financial crisis/depression.

In August 2007, few market participants, even those with access to mountains of information and a broad range of expert opinions, had a real clue as to what was going on.

Confession, your humble blogger was one of the few market participants who had a real clue as to what was going on and is still going on.

Certainly the US Congress was clueless; its members were still busy lobbying for the government-backed housing-mortgage agencies Fannie Mae and Freddie Mac, thereby digging the hole deeper. 

Our financial system is not set up to be dependent on the US Congress to see a financial crisis coming.

There are any number of market participants including the Fed who are suppose to be warning the US Congress that a financial crisis is coming.

Nor did the International Monetary Fund have a shining moment....

Am I the only one who spots a trend that any organization that is dominated by economists managed to miss predicting the financial crisis (other than the BIS and William White who the economics profession kicked to the sidelines)?

No.  The Queen of England spotted the same trend and asked at the London School of Economics why didn't the economics profession see it coming.

Central banks' state-of-the-art macroeconomic models also failed miserably – to a degree that the economics profession has only now begun to acknowledge fully. 

Although the Fed assesses many approaches and indicators in making its decisions, there is no doubt that it was heavily influenced by mainstream academic thinking – including the so-called real business cycle models and New Keynesian models – which assumed that financial markets operate flawlessly. 

Indeed, the economics profession and the world's major central banks advertised the idea of the "great moderation" – the muting of macroeconomic volatility, owing partly to monetary authorities' supposedly more scientific, model-based approach to policymaking.

Yes indeed, the models and the economics profession behind them failed miserably as stated by William White in a paper published by the Dallas Fed.

We now know that canonical macroeconomic models do not adequately allow for financial market fragilities, and that fixing the models while retaining their tractability is a formidable task. 

Frankly, had the models at least allowed for the possibility of credit-market imperfections, the Fed might have paid more attention to credit-market indicators as a reflection of overall financial-market conditions, as central banks in emerging-market countries do.

Please re-read the highlighted text as it provides a terrific illustration of why the economics profession does not understand what happened and why it hasn't been able to offer any useful advice on how to end the financial crisis and fix the financial system.

Perhaps it is not the models that need to be fixed to allow for the possibility of credit-market imperfections.

Perhaps what needs to be fixed is the economic professions understanding of how our financial system is actually designed to operate.

If you understand the FDR Framework, it is easy to see what has to be done to fix the financial system and end our current financial crisis.

Last but not least, even if the Fed had better understood the risks, it would not have been easy for it to avert the crisis on its own. The effectiveness of interest rate policy is limited, and many of the deepest problems were on the regulatory side.

This is pure and utter b.s. and reflects a lack of understanding of the Federal Reserve and the Fed's role in precipitating the financial crisis by undermining the financial system.

Specifically, the Fed is in charge of bank regulators who jealously guard their monopoly on all the useful, relevant information on each of the large banks. (I know they are housed in a building across the street from where the economists have offices, but these bank regulators are there to do something other than fill the office space below where the economists eat lunch.)

It is the Fed that is responsible for the opacity of these banks that has the Bank of England's Andrew Haldane calling the banks 'black boxes'.

It is the Fed that substituted the combination of complex rules and regulatory oversight for the combination of transparency and market discipline.

Please note, it is the Fed that is busy running stress tests on the large banks and pronouncing them solvent.  Who can challenge this when it is only the Fed that has access to the data needed to run these stress tests?

We headed into our current financial crisis with the Fed telling everyone that the level of risk at the large banks had actually gone down as a result of financial innovation.  Oops.

It is the Fed that created massive overexposure to the banks (investors, including other banks, heard the regulators say they were less risky).

It was the Fed that created the moral obligation to bailout unsecured bank debt holders.  After all, how can you expect the investor to take a loss after the Fed opines that the banks are low risk and highly solvent?

And calibrating a response was not easy. 

Actually, calibrating a response was very easy and a Bloomberg article on me in late 2007 showed just what it would take.  Simply put, it required bringing transparency to structured finance securities and all the other opaque corners of the financial system.

By late 2007, for example, the Fed and the US Treasury had most likely already seen at least one report arguing that only massive intervention to support subprime loans could forestall a catastrophe.  

The idea was to save the financial system from having to deal with safely dismantling the impossibly complex contractual edifices – which did not allow for the possibility of systemic collapse – that it had constructed. 

Such a bailout would have cost an estimated $500bn (£317bn) or more, and the main beneficiaries would have included big financial firms. Was there any realistic chance that such a measure would have passed Congress before there was blood in the streets?

Excuse me, but by late 2007, I had already presented an alternative to the US Treasury and Fed that would not have required a bailout and would have moderated the impact of these securities.

The idea for a bailout comes from the Wall Street firms and the bankers who wanted to protect their bonuses.

Please recall that under the FDR Framework in exchange for transparency investors become responsible for all losses on their investments.  By bringing transparency to the financial system, we would have seen where the losses were located.

More importantly, the FDR administration had the foresight to build into the financial system a special place to park losses:  the banks (a fact not missed by the bankers who wanted to protect their bonuses).

By design, banks can continue to operate with low or negative book capital levels.  Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, the taxpayers effectively become the banks' silent equity partner when they have low or negative book capital levels.  As a result, there is no need to formally bailout the banks.

Instead, banks with low or negative book capital levels are simply prevented from paying cash bonuses to bankers or dividends until such time as they have rebuilt their book capital levels through retention of earnings.

Indeed, it was precisely this logic that me led to give a very dark forecast in a widely covered speech in Singapore on August 19 2008, a month before Lehman Brothers failed. 

I argued that things would not get better until they got much worse, and that the collapse of one of the world's largest financial firms was imminent. 

My argument rested on my view that the global economy was entering a major recession, and I had the benefit of my quantitative work, with Carmen Reinhart, on the history of financial crises.

I believe Professor Rogoff when he tells you what went into his thinking.  He confirms that there was nothing systematic in what he did that would help in identifying the next financial crisis or ending the current financial crisis.