Dean Baker blogs about the housing bubble very well so I'm going to reproduce this post in its entirety.
The WSJ is effectively covering up for the Fed and the economics profession by implying that there was something difficult about recognizing the 70 percent jump in real house prices as a bubble or realizing that its collapse would lead to serious economic damage. The bubble was not difficult to spot for any serious analyst of the economy. The run-up was a sharp divergence from a 100-year long-trend that could not be explained by any change in the fundamentals of the housing market. It also was not accompanied by any notable increase in rents.
It also should have been evident that the bursting of the bubble would devastate the economy. This article wrongly focuses on the financial aspects of the collapse. While this is important for Wall Street, the real aspects are far more important for the economy. The bubble added more than 3 percentage points to GDP in the form of excess housing construction and another 4 percentage points of GDP in the form of excess consumption driven by bubble generated housing wealth.
This demand was absolutely certain to disappear when the bubble burst. The Fed has no mechanism that can readily replace a drop in annual demand equal to 7 percent of GDP or more than $1 trillion. (The downturn was exacerbated by the collapse of a bubble in non-residential real estate which is still in process.)
This is all very simple. None of this requires complex economic analysis, just competent economists.
It is also worth noting that the WSJ refuses to discuss what could be one of the Fed's most important tools against an asset bubble: talk. If the Fed had devoted its enormous research capacities to documenting the existence of a bubble and the likely implications of its bursting, and the Fed chairman used his enormous megaphone to widely disseminate this information at congressional testimonies and other public appearances, it would have almost certainly been sufficient to burst the housing bubble.
While economists question this possibility, since the cost is trivial (talk is cheap), there is no excuse for the Fed not following this route in addition to whatever other measures it may take.As George Harrison says, "with every mistake, we must surely be learning." And Ben Bernanke did thoroughly study the Great Depression and based his policy responses on what he had learned. And it worked this time around. Unlike Baker, I think Bernake did pretty well given the circumstances and given the natural inclinations of conventional wisdom. He thought outside the box in other words.
Andrew Ross Sorkin, author of Too Big To Fail, argues that Treasury Secretary Paulson was more the main driver, but I havn't read the book yet.
Baker writes of the popping of the bubble: "The Fed has no mechanism that can readily replace a drop in annual demand equal to 7 percent of GDP or more than $1 trillion." The popping of the bubble also caused the Great Panic as credit markets froze and overleveraged, ginormous financial institutions collapsed. (Seems the so-called Free Market/Insvisible Hand of Capitalism isn't very nimble or resilient, which is Krugman's point about the "efficient-market hypothesis" and freshwater economists.)
Via Ezra Klein, how Washington Mutual failed:
Within two hours of the call, regulators took control of a company with $307 billion in assets and sold it to rival JPMorgan Chase & Co. for $1.9 billion, a fraction of what the New York powerhouse led by Jamie Dimon had offered just months earlier.
With these swift actions, tens of thousands of shareholders and bondholders lost billions of dollars, and Washington Mutual became known as the largest bank failure in U.S. history -- nearly eight times larger than the Federal Deposit Inurance Corp.’s previous record failure, set during the savings and loan crisis of the 1980s.
Yet despite the size and significance of this event, much of what happened to WaMu has never been reported.There was a lot going on at the time. The housing bubble caused the collapse of Bear Stearns, Lehman Brothers, WaMu, AIG, Iceland, etc. Bank of America who was in bad shape just paid back its TARP money even though that leaves it in a weaker position. Via James Kwak at Baseline Scenerio, "From a liquidity perspective, it now has about $20-25 billion ($45 billion minus $19 billion raised from new equity minus a few billion from other asset sales) less cash than it did before paying the money back." Why did they do it? To avoid executive compensation caps. Kwak writes "Update: Ted K. pointed out to me that Wells Fargo, which is generally considered less of a basket case than Bank of America, is not paying back its TARP money yet."
Obama has been very lucky in some ways (mostly during the campaign like when the financial system imploded) and unlucky in others (once in office he had to deal with all of the messes Bush and the Republicans had left). On the radio I heard Christine Romer describe how she told him that that job market lost only 11,000 jobs this past month and he responded "you mean 110,000?" So, finally there's been a pleasant surprise of good news.