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Science Confirms: The Fed Was Clueless About The Financial Crisis

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When the financial crisis was bearing down on us like a speeding Mack truck in 2008, policymakers at the Federal Reserve -- our first responders in such an emergency -- were snoozing comfortably in the middle of the road.

That was pretty obvious from reading the recently released transcripts of the Fed's 2008 policy meetings, when the Fed was constantly playing catch-up with unfolding events. But now science has confirmed it in a new academic paper titled "Why the Federal Reserve Failed to See the Financial Crisis of 2008," authored by sociologists at the University of California-Berkeley.

"[T]hey had surprisingly little recognition that there was a serious financial crisis brewing as late as December 2007," wrote the authors, who studied transcripts of Fed meetings. "This lack of awareness was a function of the inability of the [Fed policymaking committee] to connect the unfolding events into a narrative reflecting the links between the housing market, the subprime mortgage market, and the financial instruments being used to package the mortgages into securities.

"[T]he fact that the group of experts whose job it is to make sense of the direction of the economy were more or less blinded by their assumptions about how reality works, is a sobering result," they added.

There were a couple of cultural problems that hindered the Fed's ability to keep an eye on the global economy, according to the paper.

For one thing, the Fed's policy committee is made up almost entirely of economists who study the world one piece of data at a time, cranking each piece into models that they think will magically predict how the economy is going to perform. They are unable to look beyond the data to see how seemingly disparate pieces of evidence might fit together into a bigger picture. They are also dependent on economic models, which failed in many ways ahead of the crisis, both at the Fed and on Wall Street.

"The relevant markets were not a product of the relevant models; to the contrary, there was a complete disjuncture between market and model, each seemingly operating according to its own logic," the authors wrote.

The Fed also could have used a few people willing to stake out extreme positions at their meetings. Too often, policymakers dismissed worst-case scenarios and stuck to conventional wisdom to avoid looking like a "loose cannon," in the paper's words. The collapse of the financial system was unthinkable, so nobody thought about it, or at least nobody admitted to thinking about it.

The paper's authors made some helpful suggestions: The Fed (and the U.S. presidents who appoint Fed governors) could bring on board some policymakers who are not classically trained economists. It could use some people who might be more willing to rock the Fed's cozy boat.

But the authors are not optimistic, ending their paper on this bleak note:

"Not surprisingly, since the events of 2008, nothing has changed on the FOMC. The next time such a complex unraveling begins to occur, one can expect the same result."

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