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In a speech last month about the financial crisis, Federal Reserve Chairman Ben S. Bernanke trenchantly noted that the initial losses from the dot-com bust were about the same size as those from the housing meltdown – yet the two episodes had very different economic consequences.
What Bernanke didn’t say was that the reason the Fed, along with every other official forecaster, underestimated the depth of the latest downturn so badly is that its models effectively treated the housing collapse as if it were merely dot-com bust 2.0. And only modest progress has been made toward avoiding that same mistake in the future.
Bernanke said in his speech on April 13, at a conference sponsored by the Russell Sage Foundation and the Century Foundation, that “any theory of the crisis that ties its magnitude to the size of the housing bust must also explain why the fall of dot-com stock prices just a few years earlier, which destroyed as much or more paper wealth – more than $8 trillion – resulted in a relatively short and mild recession and no major financial instability.”
He then pointed to the concentration of losses in the financial industry from the housing bust, as opposed to the broad dispersion of fallout from the bursting of the dot- com bubble, as the “principal explanation of why the busts in dot-com stock prices and in the housing and mortgage markets had such markedly different effects.”
The Fed chairman is right: The housing crisis was much more damaging because the initial impact was concentrated in a highly leveraged financial sector and then substantially amplified as those losses cascaded.
The problem is that the macroeconometric models used by the Fed – like those used by the Congressional Budget Office, the White House and others – had at best a very rudimentary financial sector built into them. As a result, they took into account the macroeconomic impact from the housing bust – but for the most part didn’t reflect the concentrated loss of wealth and degree of leverage in the financial industry.
In other words, the official models effectively ignored the very distinction that Bernanke highlighted as being crucial to distinguishing the housing collapse from the tech bust. And so the models completely missed the recession’s severity.