Reader Randy Tanner asks "Is Bernanke the problem?" in response to a recent article by Vasko Kohlmayer titled Why Isn't Peter Schiff Head of the Fed? In that article, Kohlmayer makes the case that over the period 2002-2007, while Ben Bernanke was saying that the economy was strong, Peter Schiff was warning us about the coming housing bust, rising unemployment, and falling dollar.
The short answer is no, Bernanke is not the problem, not in the way Kohlmayer implies, at least. The Fed did not cause the financial crisis. I personally do not like everything about the way the Fed responded to the crisis, in particular their purchase of toxic assets, but they did not cause the crisis.
And, no, Schiff should not be running the Fed, even if I believed that successfully predicted falling housing prices, rising unemployment, and a weak dollar. Which I don't. But again, not in the way you might think.
Being a good economist does not require one to predict the state of the economy during a certain window of time. In fact, the very best forecasters know to not even try to predict economic activity beyond the next quarter.
No, what good economists understand is cause and effect, and most of that occurs at the level of the firm, the consumer, or the transaction. Extrapolating that to the level of the economy involves so many countervailing factors that "predicting" what will happen at the macroeconomic level is not really meaningful. In other words, you can find someone out there at any point in time making predictions about macroeconomic outcomes who will end up being "right." Eventually. On some level. And this does not help us to make better policy, to allow the economy to be as healthy and productive as possible.
Let me give you a specific example to help make my point. And I agree at the outset that Randy's point is a difficult one to argue against, and that my point is fairly subtle. What I believe was perfectly predictable was the impact of the political decisions that mandated easier and cheaper access to home ownership, and charged Fannie Mae and Freddie Mac with implementing those policies. When the government inserts itself between suppliers and demanders, as it did with these policies, it distorts the price signal and gets either too much or too little of that economic activity.
So what happened here? Because of the mandates, banks made loans to individuals that they would not have otherwise, largely because Fannie Mae and Freddie Mac were standing in the ready to buy those mortgages from the banks and get them off the banks' books. So the banks did not have to bear the risk of those homeowners defaulting on the loan. Therefore, those mortgages were underpriced. And if the interest rates had been higher, where they should have been, less creditworthy individuals (which include high income individuals overextending themselves with a second mortgage as well as low-income individuals overextending themselves with too much house) would have not have applied for the loan in the first place.
If you lower the price of an activity, the demand for that activity rises. So the mandates led to a situation where a larger-than-sustainable fraction of existing mortgages were high risk, were susceptible to foreclosure should the economy take a turn for the worse. THAT is what is predictable, not that the economy in fact took a turn for the worse.
Left to their own devices and profit-incentives, banks are perfectly able to price mortgages and absorb the risk that a fraction of those mortgages will go belly up. And the private economy is perfectly well equipped to pool those mortgages, combine the funds, and issue and fairly price various mortgage-backed securities.
The problem centers on the fact that a politically motived player in the form of Fannie Mae and Freddie Mac used our tax dollars to pursue a social agenda instead of a dollar of profits. Mr. Schiff seems to overlook this fact as a primary contributor to the financial crisis, and Mr. Bernanke, though I suspect is fully aware of the issues surrounding Fannie and Freddie, is not responsible for what Fannie Mae and Freddie Mac do, and must enact predictable monetary policy regardless of their actions.
Again, I do have issues with the Fed's actions over the last few years, and I do worry about inflation and the loss of autonomy of the Fed to the brutish attitude of the Treasury, but those are separate issues in my mind from the supposed ability of Mr. Schiff to predict the housing crash and the financial crisis of the recent past.
It is possible to flip ten heads in a row; unlikely, but possible. And the 10th toss does not predict the 11th. They are independent events. Predicting the 11th toss based on the preceding 10 makes as much sense as predicting that housing prices will fall because they are now high. Neither prediction is based on economics. But when you use tax revenues to subsidize high-risk mortgages, economics correctly "predicts" that more foreclosures and financial distress will occur than would have otherwise. That's a prediction you can count on.