Financial crises are caused by imprudent borrowing and lending, but as former Federal Reserve chairman William McChesney Martin noted, it is ultimately up to regulators to ‘take away the punch bowl’ when the larger economy is at risk. Indeed, many have criticised regulators for failing to anticipate and prevent the 2008 crash (Buiter 2012, Gorton 2012, Johnson and Kwak 2010, Roubini and Mihm 2010). Little work has been done, however, on why regulatory agencies failed to act despite warnings from prominent commentators (Borio and White 2004, Buffett 2003, Rajan 2005). While Barth et al. (2012) is a notable exception, their analysis leaves room for a closer study of specific institutions.
Our research (Golub et al. 2014) focuses on the Federal Reserve (Fed) – arguably the most powerful economic agency in the world. Although the Fed shares regulatory oversight of the financial sector with other agencies, in the pre-crisis period it had authority over bank holding companies, and one of its longstanding core mandates is “maintaining the stability of the financial system and containing systemic risk” (Federal Reserve 2005). The Gramm–Leach–Bliley Act of 1999 recognised the Fed as the ‘umbrella regulator’ of the financial system (Mayer 2001). Also, the Fed was well placed to assess potential problems, given its unique access to information from the US financial sector via 2,500 supervisory staff, top officials with multiple contacts, and approximately 500 professional economists.
The Fed was aware but largely unconcerned
We have analysed Fed research and policy debates – particularly the transcripts of the key Federal Open Market Committee (FOMC) meetings, which are released with a five-year delay. FOMC transcripts cover one- or two-day extensive discussions of about 200 pages. Our analysis shows the Fed did not pay sustained attention to troubles brewing in the financial system.
The use of financial instruments related to subprime mortgages and derivatives – such as collateralised debt obligations (CDOs) and credit default swaps (CDSs) – exploded in the pre-crisis period (Figure 1). FOMC meetings included scant discussion of their possible systemic risks in 2004–2006, as Figure 2 illustrates with a word count of the terms CDO and CDS. In 2007 the frequency of these terms jumps when acute financial stresses emerge, and drops off again in 2008 as the FOMC becomes preoccupied with crisis mitigation rather than diagnosis.
Figure 1. Global CDO issuance, annual ($ billion)
Source: Securities Industry and Financial Markets Association
Figure 2. FOMC Transcript word counts of selected terms, 2004–2008 meetings
CDS: credit default swap; CDO: collateralised debt obligations.
Source: Authors’ calculations from Federal Reserve FOMC transcripts.
In a June 2005 meeting that discussed housing prices and finance in depth, concerns were raised, but the overall mood of the meeting was largely optimistic. While some staff members argued “housing prices might be overvalued by as much as 20 percent”, others claimed “increasing home equity…has supported mortgage credit quality” (7, 8). FOMC members’ views were similarly divided. Governor Bies emphasised: “…[W]e need to figure out where to go on some of these practices that are on the fringes. But we haven’t done a sterling job…[S]ome of the risky practices of the past are starting to be repeated” (46). Governor Olson expressed similar views, and Boston President Minehan also wondered about “the complications of some of the newer, more intricate, and untested credit default instruments” that might lead to system-level turmoil (123). However, San Francisco President Yellen, in remarks several others praised, suggested that “financial innovations affecting housing could have improved the view of households regarding the desirability of housing as an asset to be held in portfolios…” (35). Overall, Chicago Fed President Moscow’s comment that he “found the information comforting” (47) reflected the general mood. Even Governor Bies was reassured at the end of the second day of discussions: “I’m not overly concerned. Especially with the record profits and capital in banks. I think there’s a huge cushion” (151).
The FOMC rarely discussed historical precedents, notably the near collapse of the hedge fund Long Term Capital Management (LTCM) in 1998, which featured high leverage, complex financial derivatives, and a rescue brokered by the Fed. Following an FOMC meeting and a conference call in 1998, between 1999 and 2006, LTCM was mentioned in meetings only twice in passing, disregarding this prescient warning by Governor Meyer at the September 1998 meeting: “[Th]is is an important episode for us to study…We are trying to decide what is systemic risk ... I was getting telephone calls from reporters who knew more about LTCM than I did” (110).
Fed public documents also reveal a general lack of attention to systemic financial risks. Out of the 1,000–1,500 Fed documents published annually, very few discuss issues relating to systemic financial risks, before or even after the crisis, as Figure 3 illustrates in the case of CDOs and CDSs. A limited number of documents did recognise some of the problems brewing in the financial system, including a speech by Greenspan in 2005, but these concerns did not stick. Similarly, a search of all Fed-in-print documents shows that between 1998 and 2008, the LTCM case was mentioned in a total of 12 documents out of 14,253.
Figure 3. Number of Federal Reserve public documents on key financial instruments
CDS: credit default swap; CDO: collateralised debt obligations.
Source: Authors’ calculations from Fed-in-Print.org data.
Explaining the Fed’s lack of concern
Most explanations of policymakers’ failure to anticipate the crisis have limited validity for the Fed, including: 1) regulatory capture by special interest groups; 2) free-market ideology; 3) overuse of abstract academic models; and 4) narrow focus on inflation targeting. On 1), the Fed may have suffered from ‘cognitive capture’ (Buiter 2012), but there is no evidence of bribery or corruption. Indeed, Fed policymakers and staff are highly respected professionals (Barth et al. 2012). Regarding 2), notwithstanding Greenspan’s well-known free-market views, former colleagues praise “his flexibility, his unwillingness to get stuck in a doctrinal straitjacket” (Blinder and Reis 2005:7). Furthermore, FOMC members expressed a diversity of views. And, on 3) and 4), while the Fed increasingly prioritised state-of-the-art academic-style research, FOMC discussions were highly pragmatic and inflation targeting was flexible, involving ‘constrained discretion’ (Bernanke 2003, Friedman 2006).
Instead, we emphasise two aspects of the Fed’s functioning. First, both Greenspan and Bernanke subscribed to Bernanke and Gertler’s (2001) view that identifying bubbles is very difficult, pre-emptive bursting may be harmful, and that central banks could limit the fallout from systemic financial disturbances through ex post interventions. The successful response to the 2001 dot-com bubble boosted the Fed’s confidence in this strategy. On this basis, Blinder and Reis (2005: 73) conclude “[Greenspan’s] legacy … is the strategy of mopping up after bubbles rather than trying to pop them”. The 2001 crisis, however, did not feature leverage and securitisation, unlike in 2008.
Second, the literature in political science and sociology on institutional dysfunctions illuminates the Fed’s lack of concern in the pre-crisis period (e.g. Barnett and Finnemore 1999, Vaughan 1999). Several of the Fed’s institutional routines likely reinforced its complacency.
One such feature is the scripted nature of FOMC meetings. As former Governor Meyer puts it, the “FOMC meetings are more about structured presentations than discussions and exchanges…Each member spoke for about five minutes, then gave way to the next speaker” (Meyer 2004: 39). Moreover, the priority on reaching consensus on interest-rate policy limits scope for sustained consideration of broader economic concerns. Further, FOMC staff briefings and FOMC discussions centre on the staff’s ‘Greenbook’ economic analyses and projections, which reinforces the tendency for consensus. Former Governor Meyer jokingly refers to the Greenbook as “the thirteenth member of the FOMC” (2004: 34). Figure 4 shows that over 60% of references to the ‘Greenbook’ in the 2005–2007 FOMC transcripts are supportive of its analysis.
Figure 4. FOMC comments on the Greenbook, 2005–2008
Source: Authors’ calculations from FOMC transcripts.
Additionally, the Greenbook focuses on the real economy with projections based on the FRB-US model that at the time had a limited financial sector, in line with contemporary macroeconomic models. At the September 2007 FOMC meeting, as the crisis was worsening, research director Stockton observed: “much of what has occurred [in the financial markets] doesn’t even directly feed into our models” (20).
Finally, ‘silo’ mentality appears to have isolated policymaking, research, and regulatory divisions. The Fed’s Division of Banking Supervision and Regulation (S&R) staff were rarely present at FOMC meetings, and the S&R division was mentioned just eight times at the meetings in 1996–2007. Indeed, Boston Fed President Rosengren identified this issue at a March 2008 FOMC meeting: “It is great to see some bank supervision people at this table… it might be useful to think …whether there are ways to do a better job of getting people in bank supervision to understand some of the financial stability issues we think about, and then vice versa. Maybe having some bank supervision people come to FOMC meetings might be one way to actually promote some of this” (189). Also, the Fed research staff’s increased priority on publication in academic journals over policy analysis likely reinforced the FOMC’s distance from emerging financial risks.
Our findings have important policy implications. The US Dodd–Frank Act has strengthened the Fed’s monitoring of systemically important financial institutions. Our research suggests that reforms to the Fed’s institutional structure – including collaboration among its different components (research, S&R, and the FOMC) and the nature of FOMC meetings – are also important.
Barnett, M N and M Finnemore (1999), “The Politics, Power, and Pathologies of International Organizations”, International Organization, 53(4): 699–732.
Barth, J R, G Caprio, and R Levine (2012), Guardians of Finance: Making Regulators Work for Us, Cambridge, MA: MIT Press.
Bernanke, B S (2003), “‘Constrained Discretion’ and Monetary Policy”, Speech presented before the Money Marketeers of New York University, 3 February.
Bernanke, B S and M L Gertler (2001), “Should Central Banks Respond to Movements in Asset Prices?”, American Economic Review, 91(2): 253–257.
Blinder, A S and R Reis (2005), “Understanding the Greenspan Standard”, Paper presented at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming.
Borio, C and W White (2004), “Whither Monetary and Financial Stability? The Implications of Evolving Policy Regimes”, BIS Working Paper 147, paper presented at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming, 28–30 August 2003.
Buffett, W (2003), “2002 Chairman’s Letter – Berkshire Hathaway”, 21 February.
Buiter, W H (2012), “The Role of Central Banks in Financial Stability: How Has it Changed?”, CEPR Discussion Paper 8780.
Federal Reserve (2005), The Federal Reserve System: Purposes & Functions, Volume 9, Washington, DC: Federal Reserve System Publications Committee.
Friedman, B M (2006), “The Greenspan Era: Discretion, Rather than Rules”, American Economic Review, 96: 174–177.
Golub, S, A Kaya, and M Reay (2014), “What Were They Thinking? The Federal Reserve in the Run-up to the 2008 Financial Crisis”, Review of International Political Economy, forthcoming. Published online 3 July 2014.
Gorton, G (2012), Misunderstanding Financial Crises: Why We Don’t See Them Coming, New York, NY: Oxford University Press.
Greenspan, A (2005), “Risk Transfer and Financial Stability”, Paper presented at the Federal Reserve Bank of Chicago’s Forty-first Annual Conference on Bank Structure, Chicago, Illinois.
Johnson, S and J Kwak (2010), 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown, First edition, New York, NY: Pantheon Books.
Mayer, M (2001), The Fed: The Inside Story of How the World’s Most Powerful Institution Drives the Markets, New York, NY: Free Press.
Meyer, L (2004), A Term at the Fed: An Insider’s View, New York, NY: Harper Collins.
Rajan, R (2005), “The Greenspan Era: Lessons for the Future”, Paper presented at the Federal Reserve Bank of Kansas City Symposium, Jackson Hole, Wyoming.
Roubini, N and S Mihm (2010), Crisis Economics: A Crash Course in the Future of Finance, New York, NY: Penguin Press.
Vaughan, D (1999), “The Dark Side of Organizations: Mistake, Misconduct, and Disaster”, Annual Review of Sociology, 25: 271–305.