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Why Economists Should Learn Arithmetic

The current craze in DC policy circles is to create a “systematic risk regulator” to make sure that the country never experiences another economic crisis like the current one. This push is part of a cover-up of what really went wrong and does absolutely nothing to address the underlying problem that led to this financial and economic collapse.

The key fact that everyone must always remember is that the story of the collapse was not complex. We did not need great minds sifting through endless reams of data and running incredibly complex computer simulations to discover the underlying problem in the economy. We just needed some people who understood the sort of arithmetic that most of us learned in 3rd grade.

If the people at the Fed, the Treasury, and in other key positions had mastered arithmetic, and were prepared to act on their knowledge, they would have taken steps to stem the growth of the housing bubble. They would have prevented the bubble from growing to the point where its inevitable collapse would bring down both the U.S. economy and the world economy.

Just to repeat the basic facts: house prices began to diverge sharply from a 100-year long trend in the mid-90s as wealth created by the stock bubble began to exert upward pressure on real estate prices. After having tracked the overall inflation rate for 100 years, house prices were substantially outpacing inflation.

There was no remotely plausible explanation on either the supply or demand side for the run-up in house prices. Income growth was good, but not extraordinary in the late 90s. In the current decade, incomes actually fell slightly after adjusting for inflation. On the supply side, we built houses at near record rates in 2002-2006 indicating that there were no substantial constraints on building.

As another tell-tale sign that we were seeing a bubble, inflation-adjusted rents were not rising, indicating that there was no underlying shortage of housing driving up prices. Finally, housing vacancy rates were hitting record levels as early as 2002.

At their peak in 2006, inflation-adjusted house prices had risen by more than 70 percent, creating over $8 trillion in housing bubble wealth. There was no way that the loss of this much wealth ($110,000 for every homeowner) would not lead to a severe a recession and create the sort of financial crisis that we are now seeing.

In normal times houses are highly leveraged with down payments rarely exceeding 20 percent. In the bubble years, it was common for homebuyers to borrow the full value of their home and sometimes even a few percent more. It should have been obvious to any serious economist or financial analyst that when the bubble burst, there would be hell to pay in the financial sector.

In short, all the evidence was right there for anyone who cared to see it. We didn’t need some super-genius to solve the mystery. We just needed an economist who could breath and do arithmetic. But the DC policy crowd tells us that if only we had a systematic risk regulator this disaster could have been prevented.

Okay, let’s do a thought experiment. Suppose we had our systematic risk regulator in 2002. Would this person have stood up to Alan Greenspan and said that the country is facing a huge housing bubble the collapse of which will sink the economy?

Remember, before the fall Greenspan was known as “the Maestro.” Politicians, reporters and economists worshipped every pearl of wisdom that came out of his mouth. In fact, when he announced his plans to retire in 2005, many of the world’s leading economists and central bankers gathered at Jackson Hole, Wyoming to debate whether Alan Greenspan was the greatest central banker of all time.

Alan Greenspan said that there was no housing bubble; everything was just fine. Would our systematic risk regulator have said that Greenspan was nuts and that the whole economy was a house of cards waiting to collapse?

Anyone who believes that a risk regulator would have challenged the great Greenspan knows nothing about the way Washington works. The government is run by people who first and foremost want to advance their careers.

And, the best way to advance your career in Washington is to go along with what everyone else is saying. If that was not completely obvious before the collapse of the housing bubble, it certainly should be obvious now.

How many people in government have lost their jobs because they failed to see the bubble? How many people even missed a promotion? In fact, the top financial officials in the Obama administration, without exception, completely missed the housing bubble. One might think it was a job requirement.

This lack of accountability among economists and economic analysts is the core problem that must be tackled. Unless these people are held accountable for their failures in the same way as custodians and dishwashers, there will never be any incentive to buck the crowd and point out looming disasters like the housing bubble.

The reality is that we have a systematic risk regulator. It is called the Federal Reserve Board. They blew it completely. We will do far more to prevent the next crisis by holding our current risk regulator accountable for its failure (fire people) than by pretending that we somehow had a gap in our regulatory structure and creating another worthless bureaucracy.

And of course we should teach our economists arithmetic.

DEAN BAKER is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of Plunder and Blunder: The Rise and Fall of the Bubble Economy.

More articles by:

Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC. 

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