The Financial Meltdown Continues

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By Dean Baker

Virtually the only certainty in the current financial situation is there will be more problems ahead. Those who controlled the levers of economic and financial policy neglected their greatest responsibility, which was to ensure an orderly financial market and prevent exactly the sort of collapse that we are now seeing. This was a policy failure of massive proportions, not a natural disaster.

The central problem remains the collapsing housing market. The Case-Shiller 20-City Index shows a nominal price decline of almost 20 percent over the last two years, an event that few in the financial sector apparently considered to be a serious possibility. This price decline has led to an unprecedented rate of defaults on mortgages and derivative instruments.

These defaults, in turn, have raised questions about the solvency of a large number of financial institutions. This has led to an increase in the price of risk more generally and the crisis of confidence that is currently shaking financial markets worldwide.

While there is no simple path out of this crisis, it was a crisis that could have been easily avoided. If the Federal Reserve Board had acted to stem the growth of the housing bubble before it grew to such dangerous proportions, the country would not currently be facing a recession and the prospect of a financial collapse.

Alan Greenspan had the tools necessary to rein in the bubble had he been so inclined. First, he could have imposed tighter restrictions on mortgages, as the Fed has recently done. This would have prevented many of the worst mortgages that led to the subprime crisis and helped inflate housing prices.

More importantly, he could have used his platform as Fed chairman to explicitly warn of the dangers of the housing bubble. In his Congressional testimonies and other public appearances, he could have carefully explained how house prices had diverged from a 100-year-long trend in the mid-90s.

He could have pointed out that after just increasing at the same pace as overall inflation for a century, house prices suddenly jumped by more than 70 percent, after adjusting for inflation, in the decade from 1996 to 2006. He could have shown this increase was not supported by any changes in the fundamentals of supply and demand in the housing market, nor was it matched by any remotely comparable increase in rents.

If Chairman Greenspan had pointedly made the case for the existence of a housing bubble and explicitly warned of the losses likely to be suffered by individual homeowners and the huge risks being taken by financial institutions that were heavily invested in mortgages and mortgage derivatives, it almost certainly would have been sufficient to take the air out of the bubble. As a last recourse, he could have raised rates with the explicit purpose of bringing down house prices.

Instead, Greenspan repeatedly denied the existence of a housing bubble, dismissing the warnings of the small group of economists who tried to call attention to the potential dangers posed by a housing bubble. Greenspan's denials helped create a false confidence that allowed the bubble to continue to expand. It also helped to fuel the complacency in financial markets that led the country's largest financial institutions to ignore potential risks and to become very highly leveraged against their capital.

There are no easy solutions to a financial crisis of the sort the economy currently faces. It is not possible to change history, and we must work with the crisis the collapse of the bubble has created. However, it is important to recognize this crisis was entirely foreseeable and preventable.