August 28, 2009
Dean Baker
The Hankyoreh (South Korea), August 28, 2009
President Obama announced last month that he would reappoint Ben Bernanke to another 4-year term as chairman of the Federal Reserve Board. Bernanke is widely credited for preventing a full-fledged financial collapse by taking a serious of extraordinary measures to ensure the flow of liquidity to the financial system. As a result of his performance in the crisis, most observers had expected that Bernanke would be reappointed.
While Bernanke does deserve substantial credit for preventing a complete economic meltdown, the praise overlooks the fact that Mr. Bernanke bears much of the responsibility for the policies that brought the country and the world to the brink of an economic catastrophe. Even with Bernanke’s recent actions, tens of millions of people around the world still face years of needless unemployment and underemployment as a direct result of the misguided policy pursued by Bernanke and his predecessor Alan Greenspan.
The basic story of this economic disaster is very simple. The Fed allowed an $8 trillion housing bubble to expand unchecked until it reached the breaking point in 2006. It should have been easy to recognize this bubble, and evident that a collapse of a bubble of this size would lead to a severe recession.
There was a 100-year long trend in which nationwide house prices in the United States had just tracked the overall rate of inflation. At the peak of the bubble in 2006, house prices had risen by more than 70 percent, after adjusting for inflation, from their level of a decade earlier.
There were no changes in the fundamentals of the supply or demand of housing that could provide a remotely plausible explanation for this unprecedented run-up in prices. Furthermore, rents were not outpacing inflation. If the run-up in house prices was being driven by fundamentals, then there should have been at least some upward pressure on prices in the rental market.
The flood of bad loans that fueled the bubble was also not a secret. The subprime segment of the mortgage market, which are typically loans made to moderate income people with questionable credit records, expanded from about 8 percent of the market at the start of the decade to 25 percent by 2006. “Alt-A” loans, which are typically made to small business owners who have erratic income, expanded from 2-3 percent of the market to 15 percent of the market by 2006. The huge and unprecedented growth in these speculative segments of the mortgage market should have set off all sorts of alarm bells at the Fed and in other regulatory agencies.
It also should have been evident to any competent economist that the collapse of the housing bubble would have a devastating impact on the economy. By 2006, the bubble was the main force driving the U.S. economy. Housing construction, which is typically less than 4 percent of GDP, has expanded to more than 6 percent of GDP.
In addition, the $8 trillion in housing bubble wealth was also driving consumption, pushing the saving rate into negative territory. Conventional estimates of the size of the housing wealth effect put the excess consumption generated by the bubble at close to $500 billion a year.
With the collapse of the bubble, housing construction fell to less than 3.0 percent of GDP, implying a loss in annual demand of more than $450 billion compared with the peak bubble levels. If consumption adjusts fully to the loss of housing bubble wealth, then it will reduce annual demand in the economy by another $500 billion for a total loss of $950 billion, or more 6 percent of GDP. How could anyone not see this falloff in demand as a serious problem? What did they think could replace it when the bubble burst?
In the same vein, how could they think that plunging house prices would not have disastrous consequences for the financial institutions that were exposed to speculative mortgages? Housing is always heavily leveraged, with homebuyers typically putting down just 20 percent of the purchase price. In the bubble years, down payments fell to near zero, with many homebuyers borrowing the full value of the down payment (and sometimes more) with a second mortgage. Could anyone be surprised that these mortgages would default in very large numbers when house prices fell 30-40 percent?
Apparently Ben Bernanke was surprised. He was one of the Fed’s 7 governors from 2002 to 2005. He chaired President Bush’s Council of Economic Advisors for 7 months in 2005 before taking over as Fed chair in January 2006. During this whole period he never took any action to rein in the bubble. In fact, he publicly asserted that there was no housing bubble in the fall of 2005 when his initial appointment as Fed chair was being considered.
In short, Ben Bernanke bears enormous responsibility for one of the biggest mistakes in economic policy in the history of the world and he is getting reappointed as chairman of the Federal Reserve Board. This is the punishment for failure in the United States.
