The Secrets Of The Oracle And His Reserve, In Graph Form

Ryan Grim at The Huffington Post:

As top Federal Reserve officials debated whether there was a housing bubble and what to do about it, then-Chairman Alan Greenspan argued that the dissent should be kept secret so that the Fed wouldn’t lose control of the debate to people less well-informed than themselves.

“We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand,” Greenspan said, according to the transcripts of a March 2004 meeting.

At the same meeting, a Federal Reserve bank president from Atlanta, Jack Guynn, warned that “a number of folks are expressing growing concern about potential overbuilding and worrisome speculation in the real estate markets, especially in Florida. Entire condo projects and upscale residential lots are being pre-sold before any construction, with buyers freely admitting that they have no intention of occupying the units or building on the land but rather are counting on ‘flipping’ the properties–selling them quickly at higher prices.”

Had Guynn’s warning been heeded and the housing market cooled, the financial collapse of 2008 could have been avoided. But his comment was kept secret until Friday, when the central bank released the transcripts of Federal Open Market Committee meetings for 2004 and CalculatedRisk spotted it. The transcripts for 2005 to the present are still secret.

Annie Lowrey at Washington Independent:

CHAIRMAN GREENSPAN. It is proportional to whatever that number would be.

MR. OLINER. Yes. We could make the level of the red line anything we wanted to, but we could only move it in a level adjustment up and down.

MR. LACKER. But you set the scale, too, right? You could set it so that the zeroes are the same on both axes?

MR. OLINER. Right. With creative charting we could make the relationship between the two series shift up and down however we wanted. That’s why we’re stressing –

CHAIRMAN GREENSPAN. But that’s not so for the ratio between those two series. That is invariant to the scale.

MR. LACKER. Yes, that’s true; they ought to have the same zeroes it seems.

CHAIRMAN GREENSPAN. No, no. If you have a relative measure that is an actual ratio, the ratio of the two numbers is invariant to what the relative number is.

MR. LACKER. That’s right. But in the chart, the staff has the zero set at very different places on the two scales.

CHAIRMAN GREENSPAN. You can’t trust them to do it right! [Laughter]

MR. LACKER. I’m just wondering, how did you decide where to put the zero? If you put it much closer to where the zero is for the long-run Treasury rate, the squiggles in the red line would be a lot smaller.

MR. OLINER. You can make the squiggles as small or as large as you want.

MR. LACKER. Right. And your argument has to do with the size of the squiggles?

MR. OLINER. No, I think the argument has to do with the size of the gap between the two. And the current gap relative to its average over history.

CHAIRMAN GREENSPAN. The scale will not change the fact that the gap is closing. The conclusion is independent of the scale. You could try any variation you want, and that gap will always close.

MR. LACKER. The gap between these two lines?


MR. OLINER. No matter what we used for our charting convention, the gap would be relatively narrow now compared with its historical average.

CHAIRMAN GREENSPAN. Just take the ratio of the two ratios.

Confused? You should be.

The various Fed members are talking past one another about the construction of the graphs, rather than delving into their meaning. To be fair, the visuals are unusually constructed. The rent ratio is generally given — again — as the price of the home divided by the cost to rent it for a year. Their metric appears to be the annual cost of rental divided by the cost of the home. (Regardless, it shows a historical anomaly, with that red line on the upper graph suddenly diving.) Additionally, they chart their rent ratio against long-term Treasury yields, and spend more time discussing the relationship between the two than the anomaly of the rent ratio itself.

Naked Capitalism:

Translation: housing prices are still justified, if looking a bit rich. And note that this is March 2004, more a full year before leading edge conventional wisdom, as measured by The Economist, pointed out the existence of a global housing bubble (in a June 2005 cover story).

Greenspan’s rationale was that the public’s involvement would be uninformed and unhelpful (gee, it didn’t occur to him that they might have more facts on the ground…):

We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.

Other Fed members raised concerns about overly low rates. Vice chairman Don Kohn was worried that lax interest rates were propping up housing prices; Cathy Minehan, head of the Boston Fed, worried about CPI increases in her region….driven by rising shelter costs. Geithner was concerned about possible financial imbalances.

June minutes showed more debate on this issue, with the Fed’s research director and vice chairman Roger Ferguson the worrywarts. There is also a discussion of what would not be called global imbalances (see p. 8-10 in particular, which discusses how much of a fall in the dollar might be necessary).

Calculated Risk:

A key graph, presented by Fed associate research director Stephen Oliner, showed the rent-to-price ratio through Q1 2004. Oliner used the OFHEO (now FHFA) house price index. Usually the invert is presented (price-to-rent).

Here is an update to that graph through Q4 2009.

Fed Rent Price Ratio

The arrow shows the rent-to-price ratio when Oliner warned that “even after you account for the fundamentals, there’s a part of the increase [in house prices] that is hard to explain”.

Clearly the ratio was even more out of line with fundamentals in 2005.

But the OFHEO (now FHFA) price index is GSE mortgages only, and by far the worst loans were part of the Wall Street originate-to-distribute machine. Using the OFHEO house prices missed the worst loans. However the Case-Shiller index included these non-GSE transactions, so I added the blue line showing the rent-to-price ratio using the quarterly Case-Shiller National House Price index.

If the Fed had been paying attention to all house prices, the graph presented at the 2004 meeting would have been even more alarming. It was scary enough …

Matthew Yglesias:

Donald Kohn, wildly overoptimistic, says “[e]ggs will get broken when rates begin to rise, but the capital in most intermediaries is high, and the system is resilient” which makes him one of the least overoptimistic people in the room.

Calculated Risk highlights this curious June2004 comment from Stephen Oliner, the Associate Director of Research:

I don’t want to leave the impression that we think there’s a huge housing bubble. We believe a lot of the rise in house prices is rooted in fundamentals. But even after you account for the fundamentals, there’s a part of the increase that is hard to explain.

What would a bubble be if not an increase that is hard to explain after you account for the fundamentals? Now recall that this all went down only a few months after Alan Greenspan—who at the time was the most highly respected figure in American economic policy, treated with extreme deference by the press and by politicians—told people ARMs were a great deal and people should be getting more of them.

Ryan Avent at Free Exchange at The Economist:

Mr Greenspan’s point is the most interesting one, I think. It comes across as incredibly arrogant and hubristic in the light of hindsight. As it happens, the FOMC did not understand the trouble that was brewing, and to the extent that it did it failed woefully to act the mitigate the potential damage. And it isn’t surprising that the publication of these transcripts have increased the calls for oversight of and transparency at the Fed.

But would such oversight and transparancy have helped? I think many bloggers have rushed through the transcripts looking for smoking guns related to the housing bubble and financial crisis. But the FOMC members spend as much time or more on the employment situation. In March of 2004, economic recovery was more than two years’ old, but the unemployment rate was still elevated—higher than it was at any point during the 2001 recession. The stubborn persistence of unemployment clearly troubles FOMC members, as it clearly troubled many Americans.

By June, the Fed had made up its mind that other risks—asset price bubbles, inflation, financial instability—outweighed continued labour market weakness, and it began the long series of quarter-point increases in the federal funds rate target that didn’t end until housing markets had begun declining, in the second half of 2006.

So the question is, how would an FOMC with more exposure to American public opinion have acted, or how would it have acted differently? Does it seem likely that a more transparent Fed would have spent more time fretting about financial market instability and inflation and less time focused on unemployment? Or is it more likely that the opposite would have been the case? I think it is highly unlikely that a Fed more exposed to popular pressure would have been more aggressive in diagnosing and deflating a housing bubble.

Apart from that, Mr Greenspan’s quotes are taken somewhat out of context. His comment is made, specifically, in the context of the phrasing of the Fed’s statement. Several presidents have remarked that the balance of threats to the economy is unpredictable, and the motion has been made that the statement change to reflect a balance of concern between upside (inflation) and downside risks, where before inflation was less of a concern than lingering economic weakness. And Mr Greenspan is saying that with increased transparency, the Fed needs to be more careful about the language it uses lest it give markets whiplash by appearing to veer from one fear to another. Put more simply, if the language were to be changed in the March meeting and subsequent data revealed growth to be more of a worry than inflation (or something else) then the subsequent reversal would not generate a lot of confidence.

I don’t want to go out on a limb defending Alan Greenspan. His Fed continues to strike me as disturbingly cultish and woefully complacent. Obviously, the data were showing something amiss and were dismissed far too quickly. But as forehead-slapping as these quotes end up looking, I don’t think a rush to open the Fed to significant oversight of monetary policy is necessarily the right response.

Paul Krugman:

Can’t have outsiders joining in on the debate, can we? Hoo boy.

A technical note: those charts would have been even more striking if the staffers had differentiated by regions; big contrast between Flatland and the Zoned Zone, with the latter much more clearly in a bubble.

Ezra Klein:

But this is why you need to be very careful with the idea that regulation plus information is sufficient. We had regulators and they had information. And it proved totally insufficient. When I asked Sen. Mark Warner how the bill would have stopped the crisis, the first thing he brought up was the Office of Financial Research, which is there to distribute real-time information. Maybe the OFR would put the dots together and maybe it wouldn’t, but there’s a serious chance that even if it did, the top-line regulators would find reasons to ignore the conclusions of these nameless quants who don’t understand the sophistication of the risk analysis being performed on Wall Street, or the anger that the president and the Congress and the Wall Street Journal editorial page will turn on any regulator dumb enough to try and interrupt the good times based on a graph and a theory.

Felix Salmon:

It’s official: Greenspan wasn’t talking about the housing bubble, or economic policy at all, in the now-famous quote from the March 2004 minutes where he talks about the risks “of inducing people to join in on the debate”. We’ve got it straight from the horse’s mouth: Vincent Reinhart is the man that Greenspan was talking to, and he explains exactly what the context was:

Alan Greenspan’s comment was in response to a briefing I had just given on an inside-baseball topic. The FOMC had been considering moving up when to release its minutes, which are a ten- to fifteen-page summary of the discussion at the meeting. Up to then, the minutes were released after the next regularly scheduled FOMC meeting. Staff had run an experiment to see if the minutes could be prepared quickly to be released sooner—before the next meeting. (The issue was not in the drafting, but rather in incorporating comments and a final approval from policy makers with hectic schedules.) In a short briefing, I asked a narrow question whether the FOMC’s discussion of such transparency issues at the prior meeting should be included in that meeting’s minutes. (In the event, the FOMC was transparent about transparency and also did expedite the release of the minutes.)

My remarks sparked a general observation from Chairman Greenspan on limits to transparency. Specifically, he said, “We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.”

For those not familiar in parsing his prose, Greenspan was noting that letting the world know that top Fed officials were considering an issue would draw attention to that issue, which might sometimes be uncomfortable. This is a debatable proposition, to be sure, but not one that sounds conspiratorial.

That is, unless you have the imagination of Ryan Grim, who linked this obviously general discussion of the timing of the release of the minutes to the specific mention of housing prices 45 pages (and four hours in real time) earlier. To do so, Grim also had to elevate a mention about real-estate speculation by the president of the Federal Reserve Bank of Atlanta, Jack Guynn, into Cassandra’s warning. That comment, by the way, came in the same set of remarks in which Guynn noted a little later on that the price of steel fence posts had doubled.

We do at least now know what Grim means by “moments earlier”: he means “four hours earlier”.

Still, the fact is that Grim’s story about Greenspan is, in Reinhart’s phrase, “too good to check”. And it’s already found its way into the Greenspan lore, along with a lot of more accurate stories about him.


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