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The Housing Bubble Has Popped, but if We Don't Pop the Denial Bubble Another Financial Crisis Awaits

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In 2007, the housing bubble popped. That event, and the credit crisis and recession that followed, unsettled even the most seasoned economic and political observers in Washington, DC. Yet the capacity of Beltway pundits' for reimagining history is without compare, so much so that they no longer wait for a crisis to end before they pronounce it over. Maybe in 2010 another bubble will pop. I call it the denial bubble: denial that our financial system needs serious reform to prevent another financial calamity.

There are signs that the bubble is starting to pop. The "crazy community people" - as some bankers like to call people of my ilk - are no longer the only ones worried about doing too little in the wake of the greatest Ponzi scheme ever pulled on the American taxpayers. Finally, we have some esteemed company. Even mainstream economists can't believe the pass our elected officials are giving Wall Street and the banks, given the havoc they wreaked upon the economy and the harm the recession has caused to average, working people.

Read what several economists said at a recent American Economic Association meeting, as reported by Mark Whitehouse of the Wall Street Journal: "Our response has made us more vulnerable to a bigger crisis. It's distressing," said Tom Sargent, a New York University economist.

"You have only a small window in which you can really change things. It's closing already," said Markus Brunnermeier, an economist at Princeton University.

During a time when the financial system remains dependent upon taxpayers to keep the wheels turning, our representatives in Washington, DC are tiptoeing around reforms that have been needed for at least two decades and fretting about bank executives leaving their lofty perches because they aren't getting paid enough.

"If the U.S. government could credibly say (to banks): We'll never bail you out again, it (the banking system) would collapse," said Harvard University's Kenneth Rogoff.

Hello! Wall Street and the banks need the government. I know we're not supposed to kick a dog while he's down, but we are talking about $23.7 trillion in loans, investments and guarantees that our government has made available to the wizards of Wall Street, according to Neil Barofsky, special inspector general of the Troubled Asset Relief Program. We shouldn't let them up until we know they are not going to bite us in the tail again.

David Leonhardt hit the nail on the head, writing for the New York Times this week:

The fact that Mr. Bernanke and other regulators still have not explained why they failed to recognize the last bubble is the weakest link in the Fed's push for more power. Why should Congress, or anyone else, have faith that future Fed officials will recognize the next bubble?

Leonhardt continues:

So why did Mr. Greenspan and Mr. Bernanke get it wrong? The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were saying that home prices would not drop.

Last week, during Chairmen Bernanke's faux apology for not addressing the housing bubble, he argued that using monetary policy to constrain the bubble would have been a mistake. Instead, he said:

Stronger regulation and supervision aimed at problems with underwriting practices and lenders' risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates.

Chairman Bernanke's statement ignores the simple fact that he had the regulatory power to address the bubble. In 1994, Congress gave the Federal Reserve board the power to outlaw "unfair and deceptive" lending practices. The Federal Reserve board waited until July, 2008, after the crisis was in full swing, to do so. Had they done so earlier, we could have avoided most of the economic damage caused by the housing market's collapse.

As the battle for financial reform moves to the Senate, let's hope that Senator Dodd, given the recent announcement of his retirement at the end of 2010, feels empowered to pursue robust reform. The House of Representatives departed significantly from the President's strong proposals, so if Senator Dodd cannot get a better bill out of the Senate, we may lose the opportunity to prevent the next financial crisis.

Simon Johnson, the MIT professor and economist and former IMF chief economist, put it this way:

The conventional wisdom is you can't have back-to-back major financial crises...People could be very positive, but we are setting ourselves up for an enormous catastrophe.

I try to stay optimistic, and there are some reasons for hope: I'm hearing more and people expressing fears that Congress and the Administration are letting the opportunity to pass meaningful financial reform slip through their fingers. On the other hand, the echo chamber of conventional wisdom persists, and the bubble of denial still seems to cover Washington.

The "crazy community groups" warned for years about the dangers of reckless and abusive lending and securitization practices, but those with the power to reform the system- especially the Federal Reserve - did not listen.

And so we are still saying it now: Reform the financial system. Let's pop the bubble of denial, face reality, and create a financial system that is safe, accountable and treats all Americans fairly.

(To see the financial reforms supported by the National Community Reinvestment Coalition, click here or visit the Americans for Financial Reform)