The main theme of Ben Bernanke's farewell talk delivered yesterday at the American Economic Association annual meeting in Philadelphia was that Ben Bernanke was a pretty damn good Federal Reserve chairman. And the tone in the room was largely laudatory. But he did confess to one major error. He says that when he took over house prices were already heading downward and he knew further declines were likely.
But he didn't think a house price crash would be such a big deal:
However, to a significant extent, our expectations about the possible macroeconomic effects of house price declines were shaped by the apparent analogy to the bursting of the dot-com bubble a few years earlier. That earlier bust also involved a large reduction in paper wealth but was followed by only a mild recession. In the event, of course, the bursting of the housing bubble helped trigger the most severe financial crisis since the Great Depression. It did so because, unlike the earlier decline in equity prices, it interacted with critical vulnerabilities in the financial system and in government regulation that allowed what were initially moderate aggregate losses to subprime mortgage holders to cascade through the financial system. In the private sector, key vulnerabilities included high levels of leverage, excessive dependence on unstable short-term funding, deficiencies in risk measurement and management, and the use of exotic financial instruments that redistributed risk in nontransparent ways.
The big difference, in other words, is borrowing. "Leverage" to use the term of art. Most people don't borrow money to buy stock. But houses serve as the anchor asset for chains of debt. Kick the house price out, and a whole superstructure collapses. That's why it's very important that the post-crisis Fed has made significant moves to reduce bank leverage, but we ought to go further with this and we ought to question the consensus that the government should be so heavily involved in pushing households to make leveraged bets on owner-occupied housing.