Could we build a system that is less prone to error? David Wessel argues that the Fed’s lack of imagination contributed to the bust. This series was made possible by the Charles G. Koch Charitable Foundation.

Question: Who is to blame for the housing crisis?

David Wessel: Fact 1 is that the Federal Reserve was given by Congress substantial power to oversee the mortgage industry.  Not all of it, but some of it.  Fact 2, the Federal Reserve had the power to ban unfair and deceptive practices in mortgage lending and other lending and didn’t use that power in the case of mortgages because Greenspan thought it was very difficult to make a rule; it was really something that should be done case by case.  Fact 3, Greenspan was not a big fan of regulations.  Greenspan in his own book says that he didn’t agree with a lot of the laws that govern regulation in the United States.  Laws that he was pledged to enforce, but he would obey the law of course, and he did what was required by the law, but he was not a regulatory enthusiast, to say the least.  And so, he was never pressing his staff to say, how can we come up with a law that will do something here?  Fact 4, Ned Gramlich had a different view of the world.  Ned Gramlich is not a prophet, or the late Ned Gramlich was not a prophet.  He didn’t see the entire collapse of the housing bubble, or anything like that.  All he said was, there were some consumers out there who were getting some kind of lousy products and he thought it was the role of government, in this case the Federal Reserve on whose board he sat, to regulate that so that the people who were getting the mortgages would be protected.  He was a simple consumer protection argument and he and Greenspan disagreed.  Greenspan said subsequently, and Gramlich didn’t push very hard.  Gramlich and others say, give me a break; it was hard to get anything trough the Fed unless Greenspan wanted it to happen and Greenspan was not a fan of this. 

I don’t think that had Ned Gramlich been 100% successful we would have avoided the housing bubble.  I think the housing bubble was caused by a number of factors and one of them is the supply and demand question that Ed Glazer talks about, although Glazer is much more focused on what makes housing prices go up in some communities and down in other, or up less than others.  And that really isn’t what we’re talking about here.  We’re talking about a massive generalized cross the country surge in home prices, and I don’t think that Glazer pretends to explain that.  This is more like the financial bubbles that financial economists study.  So, what would have happened if Gramlich had been more aggressive, or more successful in tightening the Feds regulation of sub-prime mortgages, as in fact, the Fed has done subsequently after all the horses left the barn, they closed the door.  They’ve outlawed all the mortgages that nobody is making any more now. 

Well, I don’t think we would have avoided the housing bubble, but maybe it would have been more – I don’t think we would have avoided the housing bubble because there was so much going on, but it might have been less widespread and there might have been fewer victims.  And I think that’s all that you can say.  Obviously mortgage regulation can stop mortgage brokers, or banks, from making mortgages to people that have no income, no job, and no hope of paying back the loan.  In fact, the financial community frequently yelps that regulation will stop them from making these sorts of loans.  And Barney Frank, among others, has said, “Yeah.  That’s the point.”  So, for instance, the Congress passed a new law on credit cards.  The Fed has written rules to enforce it and that will make it harder for some people to get credit cards who probably shouldn’t get them.  Well, the same thing could have happened with sub-prime mortgages should the Fed had acted differently. 

Question: The fact that we couldn’t see this crisis coming, does this signal anything for the future?

David Wessel: In many respects, this crisis was a failure of imagination.  The authorities, Bernanke, Geithner, and Paulson, even though they had this gut sense the we might have a financial crisis, never imagined that so much could ride on the value of houses in the U.S.  And if the value of houses in the U.S. fell, which was a surprise, that that could pull down the entire financial system. 

So, one thing that tells us is that we are going to have crisis in the future, human foresight is limited, we will go through periods of lots of boom in financial markets and then lots of angst and depression in financial markets and we should not be thinking that we are going to come up with a system that prevents every crisis.  What we need to do is come up with a system that makes them less frequent, makes them less severe when they happen and somehow cushions the blow so that when they happen, they don’t have such widespread effects as this one did. 

I think that having a systemic regulator, someone who’s charged with looking across the entire financial system, makes a lot of sense.  It’s certainly better than not having one.  One of the reasons this crisis was so severe is there was a whole bunch of people going around looking at just the institutions they regulated.  In some cases there were huge institutions that nobody was looking at and in other cases, they just weren’t looking for the connections between Bank A, and Investment Firm B, and Mortgage Broker C, and Insurance Company D.  Well we can surely do a better job of that.  Whether the Fed is the right agency or not is kind of a political debate right now.  The Fed is certainly better equipped than any existing agency to do that, but one could set up a new agency to do that.  The British tried that, it didn’t work very well, but the British have done that.  So, I think that all you can say is, we should do it, but we shouldn’t be naïve.  It’s not going to cure us from any repeat of a crisis. 

Question: Can we build a system less prone to human error?

David Wessel: One can always hope, but I don’t think so.  Look, it is striking how few people were involved in the big decisions in this crisis.  And it might have been better if at some times the circle of people who participated was larger.  I was struck, for instance, for how little intervention there was from the White House in some of the key decision.  Like, should Lehman Brothers be bailed out or not?  The peculiarity of the law limits the number of Fed Governors who can sit in a room and talk about something that matters to three without calling it a meeting and having a formal notice under the Freedom of Information Act.  As a result, Michigan as often not included in the deliberations even though he was one of the financial experts who was a member of the seven-member Federal Reserve Board at the time. 

But, I mean, this is a little bit like thinking about World War II.  In the end, there were some key generals, Patton, and Montgomery, and Eisenhower, and there were lots of people involved in the decisions, but in any war, there’s going to be a handful of generals who come up with a strategy and then a lot of people who execute it and advise them.  And I’m not sure if we can hope for much more in a circumstance like this. 

You know, there are two ways to look at what just happened.  One was, it was an enormous failure of our system, our governance, and of the people we charge with protecting us from a financial calamity.  And I think all of those things are true.  But one can also say that, at a moment of great peril to the United States economy, and in deed to the global economy, somehow this small band of people managed to pull the U.S. economy, the global economy back from the abyss of depression.  So, we don’t know how the story is going to end.  We might have a decade of stagnation, and that would be horrible of course, but for the moment, I don’t think you want to complete condemn the system that put these people in place and gave them the authority to do what they did so that today, in November, 2009, the odds of another Great Depression, or back to close to zero, whereas a year ago, they were more like 30%. 

Question: Some people say our lack of understanding for basic economics got us into this mess. How should economics be taught in school?

David Wessel:  That question has a number of pieces that don't touch each other.  One thing is there was a failure of academic economics here.  Too many macro-economists underplayed the importance of finance and of financial institutions and their understanding of the world.  The relatively small number who were working in this field, Bernanke being one of them, could have used a lot more help.  So there are a lot of practicing economists who had a model view of the world that didn't turn out to be quite rich enough to cover what was happening.

I don't think that we're going to convince a whole lot of people that they shouldn't take a loan that they can't pay by giving them a high school economics course.  So do I believe that more people need sound financial education, a sense of if it looks too good to be true it probably is, a way to understand that if borrow something, some money and you're paying 12 percent interest that that could add up over time.  The answer to that is yes and we should do a better job of that and there's been endless efforts to do it and it's going to be kind of hard if you have kids who can't add and subtract but if you get past the add and subtracting thing we should be able to do that better and websites and calculators can help.

But I think that some people look at the teaching of consumer economics as a panacea and it isn't.  We are always going to have people who don't get it and it's important to think of a way to give them choices that help steer them away from really bad decisions.  I think there's a lot of new thinking in economics called behavioral economics that gives us a guide here.

We would not build a grade school cafeteria where the kids had 12 feet of dessert and then six inches of fruit, vegetables and protein.  But that's what we do in finance.  You go into a bank and there's a hundred ways that they can lend you money that you can't afford to pay back.  So one of my disappointments in the financial regulatory bill that's working through Congress is they rejected some of the proposals that the President had made that would structure these decisions so that if you went to get a mortgage you would be required to be shown if you got a regular ‘ole 30 year fixed year mortgage, this is what your payments would be and this is how much interest you would pay over time.  If you take this new fangled mortgage, this is how it's different.

So you can still get the new fangled one but you should be shown that choice.  In the credit card bill that passed, I believe there are rules that say to people -- rules that say that the credit card company has to put on the bill if you make the minimum payment -- the $29 you have to pay, the minimum -- how many months or years will it take you to pay off your balance.  That's a way to help people make decisions in real-time when they're faced with them and it's not something you can teach them in 8th grade and hope they'll remember when they're 37.

Recorded on November 20, 2009