The Fed Is More Out of It Than You Thought It Was

a | A

Jan. 28 (Bloomberg) -- The Federal Reserve recently released the transcripts of the meetings of its Board of Governors in 2007, covering a time when the first rumblings of the financial crisis were beginning to appear.

By the end of 2008, everything would have changed: The Federal Reserve expanded its lending powers to backstop the financial sector. The “Great Moderation” legacy of the Alan Greenspan era came to an end, with interest rates pushed down toward zero, while unemployment increased and inflation slowed.

As of 2007, the Fed was unprepared for what was to come, though not mainly for the reason most commentators are highlighting. The initial reporting on the transcripts has focused on whether or not the Fed saw the financial crisis coming, and most find that the Fed did not. But the Fed also missed something much more important.

For all the attention the financial crisis gets in the story of the latest recession, it isn’t that important to understanding our current weak economy. The reason that more than 12 million people are unemployed, that workers no longer quit their jobs or get raises, and that economic prospects are dim for the foreseeable future, has to do with the financial health of consumers, not the health of Wall Street.

Looking at the December 2007 transcripts, the Federal Reserve was concerned about a “credit-crunch” scenario generating a financial crisis, an event that did happen. The fear was that a financial sector that collapsed would prevent the real economy from working.

Credit Crisis

Frederic Mishkin, a Fed governor at the time, was even worried about a death spiral, where the lack of credit would decrease economic activity, which would lead to less credit, in a process that would then repeat itself.

One could imagine him and other Fed governors believing, in 2008 and 2009, that if they stopped the spiral by stopping the credit crisis, they would have done enough to prevent the recession. As such, the health of credit access through the financial sector was their top priority.

Rescuing Wall Street may have been necessary, but it was not sufficient. Research by the economists Amir Sufi and Atif Mian found that high leverage among consumers, a result of the decline in home values when the housing bubble popped, led to a sharp drop in consumption and employment. For the past few years, households have been using their available cash to deleverage, instead of consuming. Today it’s obvious that the main economic challenge lies with households, not banks.

That’s not to say the financial crisis didn’t matter at all. Recent work by the economist Gabriel Chodorow-Reich found that small- and medium-size companies that had loans from lenders hurt by the crisis had a harder time getting credit, and had to fire more people, than other businesses.

This relationship, which was found through May 2009, may account for why unemployment grew more quickly than expected in the recession. However, it can’t explain why unemployment remains high years after the government wrote Wall Street a blank check.

Throughout this period, polls of small business, such as those conducted by the National Federation of Independent Business, consistently show that the main concern is weak sales, instead of access to credit. As the economist J.W. Mason notes, credit-card debt has had an even larger percentage drop than housing debt. Overall, economists see threats of weak demand and disinflation, rather than rising prices from credit constraints, as a problem for the recovery.

‘Green Shoots’

The 2007 transcripts matter in the context of these continuing policy failures in 2013 because the Fed’s excessive focus on the financial system, and the assumption that fixing a financial crisis would fix the economic crisis, led to mistakes down the road.

When Fed Chairman Ben S. Bernanke told CBS’s “60 Minutes” in March 2009 that he was expecting “green shoots” to appear, he was largely talking about how, with the financial markets no longer in a panic, the economy would be fine to recover. This perspective, shared by many besides Bernanke, led to the pivot that the Obama administration has taken since 2010: prioritizing deficit reduction and deprioritizing economic stimulus.

The failures from the overly narrow focus on the financial sector weren’t limited to fiscal policy. In 2007, the Fed didn’t even consider that it would have to keep the economy afloat by adopting unorthodox monetary policy after interest rates hit zero, and would continue to do so even after stopping the financial meltdown. Nor did the Fed expect that it would need to use unconventional methods to continue easing after hitting the zero-bound, which is perhaps why it was years late in moving to the open-ended quantitative-easing policy adopted last year.

Aggressive measures to write down bad mortgage debt or otherwise boost consumer demand through the housing market would have helped households but threatened banks. And restoring basic accountability is hard when the financial system is seen as too fragile to tolerate criminal investigations of banks, as with HSBC Holdings Plc avoiding criminal charges for drug-cartel money laundering because of the bank’s too-big-to-fail status.

Reading the transcripts from 2007 makes it clear that, even though it didn’t understand the extent of the problems, the Fed was looking at the financial system as the main source of concern. Households, suffering from the housing-bubble collapse, were a secondary priority. An economic elite more in tune with broader prosperity could have caught the severity of the recession earlier, and made a case for the demand-stimulating monetary policy needed to recover from it.

(Mike Konczal is a fellow at the Roosevelt Institute. His blog, Rortybomb, was named by Time magazine as one of the 25 best financial blogs. E-mail him and follow him on Twitter. The opinions expressed are his own.)

To contact the writer of this article: Mike Konczal at

To contact the editor responsible for this article: Josh Barro at