William Poole's Pearls of Wisdom
And the sad thing is that all of this matters. Our ability as a nation to respond to the current economic crisis is being seriously hampered by the gratuitous ignorance of many of our economists.
I have to applaud both DeLong and Krugman for doing what they are doing because they are willing to set aside the need for political correctness that often pervades the field of academia and call out the offenders who are tarnishing the reputation of their field of interest - economics. It has become clear that it is not just government that needs dire reform in this era - so does the economics profession. This was in effect the conclusion of the paper - The Financial Crisis and the Systemic Failure of Academic Economics - that I mentioned in my previous post "Economics Research on Systemic Risks".
The focus of DeLong's and Krugman's blog posts is this op-ed in the New York Times by William Poole. Unfortunately, their response to Poole is steeped in economics jargon - that not too many people are likely to understand clearly. I'd like to take a look at Poole using the lens of recent history.
Poole is currently at the Cato Institute and was the former Governor of the Federal Reserve Bank of St. Louis (1998-2008). Here are his pearls of wisdom in the op-ed regarding the current recession (emphasis mine, throughout this post):
THE fundamental causes of this recession, unique in the experience of the United States, were mortgage defaults and the consequent insolvency of major financial firms. These insolvencies, and especially fear of them, damaged normal credit mechanisms.
The self-correcting nature of markets will ultimately prevail. We should not underestimate the power of monetary policy; with the sharp increase in the nation’s money stock starting in September, monetary policy is now extraordinarily expansionary. I believe, though without great confidence, that the recession will end in the second half of this year.
Federal policy is damaging the economy’s prospects. [...]
The mythical belief in the "self-correcting nature of the markets" aside, I found his belief that "without great confidence" the recession will end this year, to be unintentionally hilarious. More importantly, though, notice that in his assessment of the causes of the recession there is no mention of the massive burst in the asset price bubble. Rather it is just about mortgage defaults - makes it all sound so, um, normal. You might think I'm just nit-picking, but there may have been a reason why the bubble got scant mention. You see, back in 2006, Poole, in the face of contrary data was peddling the most pernicious kind of garbage that got us into this mess in the first place. Via DeLong commenter Ricksters, here is a MarketWatch article from March 2006 where Poole's transcendent pearls of wisdom were captured:
The U.S. housing market should remain strong in 2006, and there is no national real-estate bubble that's about to burst, St. Louis Fed President William Poole said Wednesday.
Uh-huh. It only gets more exciting from there on. The comments by Poole were from a speech he gave, which you can find on the Federal Reserve web site here. You can read the whole speech but let's extract some key portions, starting with this:
Rapid increases in house prices over the past few years have elicited much commentary, pro and con, about a price bubble. In a market economy, prices adjust to supply and demand conditions. Given that houses are assets with a long life, demand and supply depend importantly on expectations about the future—expectations about price appreciation, building costs and regulations, household income, interest rates and so forth. At various times throughout history, as the 1990s telecom boom recently demonstrated, expectations of future prices can become detached from their fundamentals. In practice, there is no perfect definition of a price bubble; so, identifying a bubble in real-time is inherently a judgmental exercise. Indeed, given that bubbles always burst—if there is no burst, then there was no bubble—clear advance evidence of a bubble can never exist. If the evidence were clear, then everyone would know about the bubble and forthcoming burst, but then the buying that created the bubble would not occur in the first place. So, if you have an academic interest in house prices, I recommend that you wait a few years. If you have a direct financial interest, I can’t help much—you’re on your own!
The portion in bold is probably the stupidest thing I have ever heard a mainstream economist say and is extraordinarily revealing of the bubble in which Mr. Poole lives in - a bubble that is divorced significantly from reality and betrays a lack of understanding how real human beings operate in a world that is characterized by the highly inefficient, and often limited, transfer and communication of critical information. In fact, his very speech is a great example illustrating how utterly stupid his claim was at the time. There were, in fact, experts calling a housing bubble at that point - this is what Poole was responding to. One could say that speculators and home-owners should have heeded the call that there was a housing bubble and not worsen the problem. Yet, at the same time, jokers like Poole were peddling nonsense about how there was no housing bubble nationally and that it is not possible to predict bubbles - the exact kind of behavior that confuses average homebuyers and speculators, makes the evidence for a bubble less "clear" in their minds, and prevents them from reacting to an actual bubble, given that the comments were coming from the President of a Federal Reserve Bank - a supposed "expert". Poole of course didn't have the slightest idea that his very comments were evidence that his theory was stupid - and I wouldn't be surprised if he is still clueless on this matter given his fondness for the "self-correcting nature of markets".
Poole also downplayed the warning signs from a sharp increase in the price-to-rent ratio:
Housing experts employ several approaches to attempt to determine the reasonableness of house prices. One links the house price to a measure of household income or the price that consumers would have to pay to rent the house.(2) One measure of the latter is the owners’ equivalent rent component of the consumer price index. Since 2001, the OFHEO and National Association of Realtors measures of house prices have risen 55 and 49 percent, respectively, while rents have only risen 16 percent. These observations indicate that the price-to-rent ratio has risen noticeably and might be read as suggesting that house prices are excessive.
However, a recent study by the Organization for Economic Cooperation and Development suggests that U.S. house prices are not particularly unreasonable based on housing fundamentals.(3) Economists at the New York Fed, using a similar analysis, have come to the same conclusion. Researchers at the St. Louis Fed also reached a similar conclusion based on an analysis that used a price-to-income measure.(4) The conventional view, which I subscribe to, is that a housing price bubble does not exist on a national average basis, but there may be pockets of the country where prices have risen beyond levels that can be justified by economic fundamentals.
He concluded his speech with the following:
Nationally, recent surveys of consumers—such as the well-known University of Michigan consumer sentiment survey—suggest a marked increase in reticence by consumers to purchase a home. My hunch, though, is that housing activity will stabilize and remain at a high level this year. I base this forecast on the belief that the FOMC will keep underlying inflation low and stable, and that the growth of real household income will recover nicely due to the waning influence of last year’s spike in energy prices. Continued healthy job growth will also help keep housing conditions at a high level.
That said, some slowing in the growth of average home prices nationally seems a reasonable expectation at this juncture. Accordingly, the marginal contribution to the pace of consumer spending stemming from the wealth effect—that is, from households extracting a portion of their home equity to spend on goods and services—is not likely to be a significant concern. The reason is that other economy-wide developments—especially income and employment growth—typically exert a much greater influence on the consumer’s pocketbook and spending habits than does the state of the housing industry.
Notice the overarching focus on inflation and excessive focus and reliance on the magic of monetary policy, the very aspect that Krugman criticizes Poole for in his post. Back to the MarketWatch article:
Rapid increases in house prices over the past few years have led to much speculation in the media and financial markets about a price bubble.
Economists at Goldman Sachs said their research has led them to conclude that home prices are 20% overvalued at present, although the regional variation is enormous.
Poole said it's nearly impossible to forecast a price bubble.
"The conventional view, which I subscribe to, is that a housing-price bubble does not exist on a national average basis, but there may be pockets of the country where prices have risen beyond levels that can be justified by economic fundamentals," Poole said.
This is the guy whose predictions about the economy and the best recovery path that we are being asked to listen to. Thanks, but no thanks.