Over at Equitable Growth: I am very happy to be here this morning to introduce the Oregon Economic Forum's Keynote Speaker, Doug Elliott of the Brookings Institution, and to set the stage for his talk.
To do that, let me ask all of you to cast yourselves back to 2006, to the end of Alan Greenspan's long tenure as Chair of the Federal Reserve, and to the days of what was then called the "Great Moderation". During Greenspan's term starting in 1987 the unemployment rate had never gone above 7.8% and it had gotten as low as 3.8%. The attainment of low unemployment under Greenspan did not signal any forthcoming inflationary spiral: The peak 12-mo PCE price index core inflation rate during Greenspan's tenure was 4.7%. The peak inflation rate that followed that 3.8% unemployment rate was 2.4%. Inflation had not been above 2.5% since December 1993. READ MOAR
This superb macroeconomic performance had not been the result of "good luck" understood as an absence of macroeconomic disturbances and shocks. We had seen the 25% fall in the stock market in one day in October 1987, the S&L financial crisis of the early 2000s, the Mexican peso crisis on our southern border in 1995, the East Asian financial crisis of 1997, followed the next year by the bankruptcy of Russia and then by the collapse of the world's then-largest hedge fund LTCM in the same year. 2001 had seen the collapse of the dot-com bubble, and the terror-attack on New York and the Pentagon on 9/11. Plus there had been large longer-term surges: the high-tech boom of the 1990s, the enormous Chinese export surplus surge of the late 1990s and 2000s, the Argentinian crash of 2002, the era of the global savings glut of the 2000s, the American construction and house-price boom, and the extraordinary rise in financial sophistication as the growth of derivative securities allowed risk to be finely sliced and diced and sold off to those who wished to hold that particular risk or make that particular bet. All of these held the prospect of producing significant macroeconomic disturbances to the underlying real economy of America. None of them did. Recessions were short. And small. And infrequent.
The conclusion that the economics profession--at least the macroeconomic mainstream of it--drew from this--call it 1984-2007--"Great Moderation" generation was that monetary policy had finally figured out how to do its proper job. A Federal Reserve that had painfully reestablished market trust in it as the guardian of price stability had set solid anchors foe inflationary expectations: no more creeping or trotting inflationary spirals. A Federal Reserve that no longer had to worry about making its bones with respect to its credibility as a price-stability guardian was thus free to throw its weight around and not fine tune but at least grossly adjust the economy to try to keep employment at high even if not full levels and growth and investment strong.
In such an environment allowing experimentation in the financial sector appeared to be wise. The large persistent gaps in average rates of return across asset classes appeared to economists to suggest an outsized price of risk. Financial innovation and experimentation that promised to generate forms of risk more investors would be more willing to bear more cheaply seemed to promise an improvement in economic efficiency. The risks of allowing and in fact encouraging cowboy finance appeared to be small: the princes of Wall Street had every incentive in their own portfolios and options to manage risk correctly, and in the experience of the Federal Reserve since the mid-1980s strongly indicated that whatever shocks were generated by financial disturbances the Federal Reserve could build firewalls to keep them from materially and significantly damaging the real economy of demand, employment, production, and incomes. And the peripheral financial crises--Argentinian, Russian, East Asian, Mexican? Not, the consensus of North Atlantic economists was, likely or perhaps even possible in the deep and sophisticated financial markets of the North Atlantic.
Thus when Raghu Rajan, then Chicago Business School professor and now head of the Reserve Bank of India, stood up at the Federal Reserve's Jackson Hole Wyoming conference in 2005 and said not just that there were large risks of financial crisis but that we had no grasp of what the risks were, the response was a general hooting. My friend and patron Larry Summers told him that the "slightly Luddite premise of [his] paper" was "largely misguided". The very sharp Armenio Fraga said that "risk is going where it belongs... we may be better off than before... [and] less of an impact of all these financial accidents on the real economy". The only defender he had was Alan Blinder, who wanted to: "defend Raghu a little bit against the unremitting attack he is getting here for not being a sufficiently good Chicago economist..."
And so when we went into 2008 we--certainly I--thought that the situation was serious but not desperate, that the likely outcome would be a small recession like 2001, and that certainly by 2011 we would be back to normal if we took the situation sufficiently seriously--which I was highly confident that we would.
It turned out that the Federal Reserve did not have a power to build firewalls to protect the real economy of demand, employment, production, and incomes from the consequences of financial distress--and, in its origins, not all that much financial distress either. We built at most one million houses above trend during the housing bubble, and--without the snowballing and feedback vicious circles--there were only a couple of hundred thousand dollars of mortgage debt on each that was not going to be repaid and had to be allocated as losses. Triple that for losses on existing homeowners who became overextended, and we still have only $600 billion of losses due to bad investments. Yet those $600 billion of fundamental losses which should have been there barely noticeable in the world economy of $80 trillion of financial assets triggered a more than $20 trillion collapse in financial values, and landed us here.
Now Doug Elliott is here to tell us why, exactly, I and so many others were so mistaken in our estimates of the situation back in 2007, and what is to be done next.