Looking Back on What Went Wrong

President Obama and the U.S. Congress (well, the Democrats anyway) are close to putting the finishing touches on legislation that will both reform and modernize the regulation of America’s financial sector. It is felt that this reform will create a more transparent and efficient financial system. The irony is that while most of the debate that took place in crafting this critical piece of reform legislation focused on the concept that if the right set of regulations had been in place the last six years or so, then the current crisis would have never happened. This perspective of our financial crisis is wrong—all wrong.

What caused this crisis was a serious failure on the part of our nation’s regulators and to some extent, those who call themselves economic professionals. Because both the administration and Congress have somehow not recognized this truth, much of the regulatory reform effort that will ultimately come out of this legislation will be weak and incorrectly focused which unfortunately means that we will have done little to keep another economic crisis from kicking us in the stomach.

One of the more smarter and able economists, Dean Baker, who serves as the co-director of the Center for Economic Policy and Research, said it best when he wrote last year, “The central problem, which we should force every regulator to say 10,000 times, is that the U.S. had a huge housing bubble. The existence of an $8 trillion bubble guaranteed a severe economic downturn when it burst. This would have been true even if there were no dodgy subprime mortgages, exotic collaterized debt obligations, credit default swaps, or over-leveraged investment banks.”

As the economy folded onto itself, people started to fear for their jobs and as that fear turned to reality, the economy in America lost approximately $1 trillion in annual spending which disappeared into the collapsing housing bubble. This is the primary reason that the U.S. economy today staggers under a rate of unemployment that stubbornly hovers around 10.2 percent.

All of the screaming on the right about Wall Street bailouts (which is kind of like a mother eating her young) and the onslaught of failing banks has been mere distractions. Financial misconduct is the reason why Americans today are suffering from unemployment, high prices, fee hungry banks and a general sense of malaise that has settled onto this country.

It is extremely important that we understand this. All our financial regulators had to do to prevent this crisis was to recognize the bubble and take proactive action before the crisis exploded out of control. For the last century, housing prices across the nation had mirrored the rate of inflation and all of a sudden, sometime around the mid 1990s, housing prices began to race ahead of inflation, eventually rising more than 70 percent.

With the exception of Dean Baker and a handful of other economists, no one could explain this sudden surge in housing prices. How could regulators have possibly missed the coming economic earthquake when there was this 100 year track record in the largest housing market in the entire world unless it was all smoke and mirrors, unless it was a housing bubble? And even, the largest bubble ever formed, eventually bursts—and boy did this one ever burst. If any regulator alive can come up with an excuse for their failure and the failure of the Fed to see the housing bubble coming I would certainly like to hear it.

What is even worse in my mind is that if they were aware of the growing housing bubble but failed to act and even more importantly failed to grasp the bubble’s significance in that it would ultimately devastate the American economy, then tell me, what good are they?

In a rush to defend themselves, regulators have argued that they simply lacked the necessary tools to keep the bubble from bursting and to bring it under control. This argument lacks credibility because if first Greenspan and then Bernanke would have just used the resources and the bully pulpit of the Fed to expose the bubble, the Bush administration might have been able to preemptively collapse the bubble before it blew up on its own.

Sadly, history tells the story that our Fed did nothing to control the bubble and what is even more mind boggling is that their inaction was hailed by economists all over the country—save for the very few who recognized what was happening and whose warnings fell on deaf ears.

What this crisis has taught me is a lesson that is critical to understanding the nature of regulatory reform and how it should be shaped. Economists as a group have always been regarded somewhat by the rest of us as the best and the brightest, and as we watched them spin their tales of economic models, engines and abstractions, in the end, they are just like the rest of us. Their fancy degrees notwithstanding, economists are somehow, almost more than any other profession, infected with a serious herd mentality virus and are completely incapable of being able to think independent of one another. How else could they have, in almost choir-like fashion sang the praises of the economy as the $8 trillion housing bubble blew up in their faces?

As much as I hate to admit, the most critical and vital thing this administration could have done to make regulatory reform a reality, would have been to fire Ben Bernanke for at best, being asleep at the wheel. No punishment, no lesson learned. So instead, this administration spent valuable political capital on keeping Ben Bernanke in office.

I realize that Sun-Tzu said to “Keep your friends close, and your enemies closer” but this is too much.