Janet Yellen in Real Time

Janet Yellen in Real Time
October 29, 2013

Clifford Thies

Clifford F. Thies is the Eldon R. Lindsay Professor of Economics and Finance at Shenandoah... (read full bio)

Did Janet Yellen, in real time,

(1) see any problem in the housing bubble,

(2) anticipate the bursting of the housing bubble; and,

(3) anticipate its implications for the U.S. economy?

The answers are (1) no, (2) no, and (3) no. Why, then, is she being plumped as the Oracle of the Crash of 2008.

We begin in 2004. By this time, the housing bubble was well underway. Yellen has just assumed her position as President of the Federal Reserve Bank of San Francisco. This is bad news. It means that from here forward practically every word of hers is recorded and scrutinized. This is not good for those who – like Stalin’s photographers – would like to air-brush history. So, what did she say about the housing bubble? In her first public speech as President of the San Francisco Fed, here is what she said:

 “…with the major declines in mortgage rates behind us, the volume of mortgage refinancings has plummeted over the past year or so. Conceivably, equity withdrawals from cash-out refinancings provided a greater boost to spending in recent years than was commonly recognized, and the loss of this source of funds could undermine demand.”

INTERPRETATION: She didn’t notice the bubble. Instead, she was thinking like a Keynesian economist. A house can be a source of liquidity, enabling people to spend more, which adds to aggregate demand, which is a good thing. Or, is continually borrowing against your home a good thing? Today, looking back, maybe not.

Continuing into 2005, the signs of the bubble are now unmistakable. Was Janet Yellen worried? Even if there were a bubble (notice the “if” word), her answer, like Amy Winehouse’s answer when they wanted to send her to Rehab, was "No, no, no."

“First, if the bubble were to deflate on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble? My answers to these questions, in the shortest possible form, are ‘no,’ ‘no,’ and ‘no.’”

As to whether there actually was a bubble, she doubted it. Yes, homes were overpriced as compared to rent. But, interest rates were low, and homes were affordable. By the way, one of the reasons interest rates were low was the low interest rate policy of the Fed at that time, which Yellen supported.

 Continuing into 2006, by this year, the overpricing of homes was becoming obvious. Yellen considered the matter, and admitted that there were some “inflationary pressures”; but, all things considered, she wasn’t worried. Her 'best guess' is that the economy would transition into “sustainable” growth.

“If growth were to continue to roar—that is, to keep running at an unsustainable pace for too long, raising the risk of building inflationary pressures—monetary policymakers like me would start getting those frowny lines in their foreheads. But, at the moment, my brow is fairly smooth. My best guess is that economic activity will remain healthy, supported by strong productivity growth and continued strength in consumer spending and business investment, especially investment by the vital high-tech sector. But I don’t think we will get a repeat of the very rapid first quarter growth. Rather, I expect economic activity to settle back to a more trend-like and sustainable rate as the year progresses.”

By 2007, softness started to show itself in the housing market. Home prices were no longer rising, and unsold homes started to dot the landscape. Yellen was aware of the potential problems, but she did not distinguish herself among the leaders of the Federal Reserve in warning of the problem.

“The most consistent voice” in that regard, according to the New York Times, was the Chairman of the Federal Reserve, Ben Bernanke. They said, 

“’The speed of the falloff in housing activity and the deceleration in house prices continue to surprise us,’ Janet Yellen, then president of the Federal Reserve Bank of San Francisco, said in September.

“One builder she spoke with,’ she said, ‘toured some new subdivisions on the outskirts of Boise and discovered that the houses, most of which are unoccupied, are now being dressed up to look occupied — with curtains, things in the driveway, and so forth — so as not to discourage potential buyers’ …

“But the Fed’s chairman, Ben S. Bernanke, appears as the most consistent voice of warning that problems in the housing market could have broader consequences.

"The general consensus on the board, summarized by Mr. Geithner, was that problems in the housing market had few broader ramifications. ‘We just don’t see troubling signs yet of collateral damage, and we are not expecting much,’ he said at the September meeting.”

In Yellen’s defense, notice that she wasn’t the only leader of the Federal Reserve who didn’t see the risk to the financial system posed by the softness in housing. Neither did Timothy Geithner, then President of the New York Federal Reserve Bank, who as President Obama’s first Secretary of the Treasury would oversee the bailout.

Furthermore, it is not clear what the Federal Reserve could have done in 2006 to address the problem. Possibly, the Federal Reserve could have advised the Congress that mortgages significantly in excess of the market value of the homes backing them combined with costly foreclosure threatened the financial system and the entire economy, and promoted some way to facilitate the writing-down of mortgages. But, this is hindsight.

Even as late as 2007, as the housing bubble was bursting, Yellen still did not see the threat this posed to the financial system or to the economy. To her, the risk was to individual investors, not to the system.

“For the conduct of monetary policy, the main question is how recent financial developments and other economic factors affect the outlook for the U.S. economy and the risks to that outlook. The reason this is the main question is that monetary policy’s unswerving focus should be on pursuing the Fed’s mandated goals of price stability and full employment. Monetary policy should not be used to shield investors from losses. Indeed, investors who misjudged fundamentals or misassessed risks are certain to suffer losses even if policy is successful in keeping the economy on track.”

What we know is that, once the Crash of 2008 got underway, the approach taken first by the Bush administration and then by the Obama administrations was to allow the process of foreclosure to run its course, with selective assistance that mostly helped nobody, and to bail out the financial institutions deemed too big to fail.

 It is unfair to Janet Yellen for her to be promoted for having forewarned the country of the housing bubble. One of the problems of bubbles is that they are very difficult to discern in real time. They seem, recurrently, to generate themselves; often, in conjunction with actual advances.

The dot.com bubble of the 1990s was not based on nothing. It was based on a tremendous advance in technology. So, too, the housing bubble. Tell me what is wrong with increased home-ownership? Yet, looking back, it is obvious bubbles got underway.

The question is, why did the bursting of the first mainly affect only private investors; and, the bursting of the bursting of the first mainly affect only private investors; and, the bursting of the second devastate the financial system and the overall economy?

Clifford Thies

Clifford F. Thies is the Eldon R. Lindsay Professor of Economics and Finance at Shenandoah... (read full bio)