Greenspan claimed in testimony before Congress, that default data on sub-prime loans was too slow coming in, which prevented the Fed from acting quick enough to head off the problem.

After stating the fatal flaw was the failure of the self interest of bankers to align with the interest of depositors and investors, Greenspan's only appeal to evidence of a problem was a delay in sub-prime data.

Greenspan never acknowledged a problem existed until the sub-prime data came in, and after the fact, his only regulatory recommendation going forward was to require lenders to have "more skin in the game", implying a tighter connection between lenders and borrowers, asserting all other problems had already self corrected themselves in the market.

I'm from Australia, I read your column regularly.It's great. Quick question. Australian housing experienced bigger bubble then US/UK/Ireland yet our housing not only did it not go bust, but it keeps on going up. We have the least affordable housing in the world. There is only 21 million Australianas and Australia is a big empty contitent. Why is Australian housing so expensive and overprised? Yes we do have buble but it does not want to go away? Common Dean, break it down for me.
Thank you!

I strongly object to your interpretation, but if I am wrong, I am happy to be corrected.

1) Situation 1: There is a housing bubble and people who can afford the inflated prices take mortgages. Bubble pops - the world is fine, the economy is stable those people lost equity but that is all.

2) Situation 2: There is a housing bubble and people who cannot afford the inflated prices get mortgages - WITH THE BANKS LENDING THEM THE MONEY. Now, bubble pops, these speculators default, economic cascade occurs SPECIFICALLY because banks are overleveraged.

So I argue that 1) The post is right, everything would have been fine if banks did not engage in loose lending. 2) You probably addressed this elsewhere (link if so?), but supposing Greenspan/Bernanke saw what was going on, what powers could they use other than going public? Even if the fed had kept high interest rates, I am not convinced that would have prevented the bubble - though with less liquidity in the market perhaps it would have been smaller. Of course, there would be other effects (nonbubble) which we would have to take into account too then.

Aditya Savara wrote, ...but supposing Greenspan/Bernanke saw what was going on, what powers could they use other than going public?

First, as Dean has written, that's a huge power. Not only would it have a dramatic psychological effect on "the herd," but it might make any money manager who subsequently lost money when the bubble burst vulnerable to a lawsuit.

Second, IIRC the Fed has the power to regulate mortgages. So the Fed itself could have tightened lending standards.

Aditya - the loss in housing wealth reduces consumption.

Thanks Ben,

let me also add that I really do not think the financial disruptions are a major factor in the current downturn. We have seen a falloff in consumption as we would expect given the loss of housing wealth (actually probably a bit less than expected). We have seen collapses in residential and non-residential construction which are caused by enormous excess supply.

Investment and S&L government spending have followed demand and tax revenue downward. Where does the financial crisis fit in this story other than in the headlines of newspapers obsessed with Wall Street's problems.

Loose lending standards caused by a mis-evaluation of risk DID cause the crisis.

Maybe having the fed increase interest rates would have averted it but maybe not.

The key to a bubble is that people believe that "things are different this time".

If people (including those at banks) have a bubble mentality and believe housing prices can never go down then having interest rates be a percent or two higher would not necessarily have popped the bubble, especially given the widespread use of teaser loans which have below market rates for a short time before rising.

How high do you think the fed should have raised interest rates to pop the bubble?

2%? 5%?

Mr Baker,
I, for once, strongly disagree with you: In the run-up to the crisis, lending standards totally collapsed, especially in mortgage lending. Of course, this was due, in part, to the bubble in the real estate market. Conversely, loose lending standards drove up real estate prices, thereby feeding the bubble. Greenspan and Bernanke made grave mistakes to be sure, but bad behavior on the part of the banks is central to the story.

Note to h in Australia:
This is not my field, but since no one else is talking about the Aussie Bubble, I might as well offer two thoughts:
First, it might be connected with the Hong Kong Bubble, fueled by wealth from Mainland China? (partly fueled by our own imprudence?)
Also, there might be internal subsidies at play, things to promote property-flipping?

If loose lending standards and the ensuing defaults had been the "cause" of the financial meltdown, then specifically addressing that problem by keeping people in their homes would have solved it. Better to say the defaults were the catalyst--instrumental in triggering it but in a sense, outside the process once it ran its course.

How could "keeping people in their homes" have solved the problem? The problem was that they couldn't afford the home they bought, they couldn't service the loan they took out. "Keeping them in their homes" would have just subsidized their housing costs for another ??? years - the banks/lenders would still have taken the hit, month after month, year after year, of the fact that the borrowers couldn't afford to pay. Loose lending standards, negative amortization loans, and zero down payment loans were the basic underlying cause of the bubble, and the culprits were (in no particular order):
1) The reckless, irresponsible borrowers,
2) The reckless, irresponsible lenders, and
3) The reckless, irresponsible regulators.

One of the best parts of Obama's speeches is that they seem to implicitly acknowledge his limitations. In this speech, Obama said "Even those of us with the best intentions will at times fail to right the wrongs before us." For liberals, that may be the lesson of the first year of Obama's presidency.

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