A Look Behind the Curtain
Topic: Investments
November 20, 2015
Image used with permission: iStock.com/Sergey Nivens
A Look Behind the Curtain
If you asked a group of people to identify the most influential economic event of the past decade, chances are the responses would coalesce around a single answer: “the Financial Crisis of 2008”. In many ways, it was the defining event of the first decade of the 21st century as well as one of the least anticipated financial crises in history.
But why didn’t the U.S. Federal Reserve – one of the world’s most sophisticated financial institutions – see the crisis coming?
On this question, we may finally have some answers to what the Fed was thinking. A recently published paper1 provides some interesting insights into the closed-door conversations that took place at the Fed in the years leading up to the financial crisis. The authors studied the transcripts of the Fed’s internal meetings from 2004-20082 and made the following observations:
- The risks were known, but seldom discussed. The transcripts reveal that in the run-up to the crisis, Fed officials discussed the potential of a housing bubble. They were also aware of the potential risks that accompanied the complex financial derivatives built on the housing market. Both of these known risks were critical factors that ultimately led to the financial crisis. However, even though the risks were known, the concerns never reached the critical mass required to trigger action from the Fed. In other words, the Fed was aware that problems existed, but seldom discussed them, and never deemed them dire enough to justify a regulatory response.
- The Fed misjudged its ability to repair the damage of a burst bubble. The authors also describe a ‘dominant paradigm’ that guided Fed thinking prior to the crisis: that it would be better to manage the repercussions of a burst asset bubble than to preventively prick one. In part, the Fed did not take action to prevent the crisis because its members believed that intervention would have caused more problems than it solved. Not only that, they also saw bubbles as notoriously difficult to spot in the first place. They also believed they had the tools and the skills to manage the situation should there be a negative turn of events. Unfortunately – and quite dramatically – the 2008 crisis demonstrated that the Fed misjudged its ability to ‘mop up’ after a bubble had burst.
- Other explanations, in isolation, are too simplistic. It’s tempting for people to blame the Fed’s disregard on what’s known as “regulatory capture” – the idea that the Fed became too intertwined with the banks they oversaw, and were essentially co-opted by Wall Street. This line of thinking, argue the authors, is just too simplistic and unsupported by the evidence contained in the transcripts. Similarly, the theory that the Fed was institutionally biased towards free-market ideology and therefore irresponsibly shunned regulation is also an oversimplification. More likely, a combination of factors – led by the dominant paradigm described above – were what caused the Fed’s failure to act.
While it’s certainly interesting to get a glimpse behind the curtain of the Fed’s thinking prior to the 2008 crisis, the transcripts don’t offer much hope that our ability to predict the next crisis is radically improved from the last time around. Sadly, economic and financial research have yet to deliver a reliable approach to the prevention of financial crises. Yet, even if a theory did emerge we would all be wise to heed the words of the late Yogi Berra: “In theory there is no difference between theory and practice. In practice there is.”
1. Stephen Golub, Ayse Kaya & Michael Reay (2014): What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis, Review of International Political Economy.
2. The Federal Reserve makes these transcripts publicly available five years after they are recorded, which is why the analysis has only recently been published.