The Fed Was “Supposed” to Command Such Superior Information As Ought to Have Allowed It to See the Subprime Crisis Brewing

The most recent financial crisis has allowed the Fed to achieve one of its most impressive public relations feats, to wit: convincing the public that the crisis, instead of supplying more proof of its inadequacy, shows that it’s now working better than ever. To accomplish this, the Fed has had to argue that, had it not been for its interventions, the outcome would have been much worse. Typical of this spin is San Francisco Fed President John C. Williams’s (2012) observation that, at the end of 2008, the U.S. economy was

teetering on the edge of an abyss. If the panic had been left unchecked, we could well have seen an economic cataclysm as bad as the Great Depression, when 25 percent of the workforce was out of work. . . . Why then didn’t we fall into that abyss in 2008 and 2009? The answer is that a financial collapse was not—I repeat, not—left unchecked. The Federal Reserve did what it was supposed to do.

But did the Fed really do everything “it was supposed to do” to contain the crisis? Is it even certain that its interventions made the crisis no worse than it would have been otherwise? There are good reasons for believing that the correct answer to both questions is “no.”

The Fed was, first of all, “supposed” to command such superior information as ought to have allowed it to see the crisis, or at least some trouble, brewing. After all, according to the San Francisco Fed’s “Dr. Econ” (FRBSF 2001), “Federal Reserve operations and structure provide the System with some unique insights into the health of the financial system and the economy,” providing it “with firsthand knowledge of the conditions of financial institutions.” In fact, Fed officials never saw what hit them. As the Federal Open Market Committee’s (FOMC) 2006 transcripts make clear, that committee was convinced at that late date both that a housing market downturn was unlikely and that, if such a downturn occurred, it would not do much damage to the rest of the economy. New York Fed President Timothy Geithner, for example, observed that “we just don’t see troubling signs yet of collateral damage, and we are not expecting much,” while Janet Yellen did not hesitate to congratulate outgoing Fed Chairman Alan Greenspan for leaving “with the economy in such solid shape.”

—George Selgin, “Operation Twist-the-Truth: How the Federal Reserve Misrepresents Its History and Performance,” in Money: Free and Unfree (Washington, DC: Cato Institute, 2017), 278-279.