Yellen and banks crashing the economy

Janet Yellen has done very well in economic forecasting, but she didn’t get everything right:

 Yellen’s big error here wasn’t underestimating what a deflating housing bubble would mean for the real economy, but rather what it would mean for the financial one. Back in 2005, she didn’t appreciate how much shadow banks relied on AAA-rated mortgage-backed-securities (MBS) as collateral to fund their day-to-day operations — or how much even this supposedly high-quality collateral could go bust if housing did. Of course, that’s exactly what happened, and it set off a run on the shadow banking system that forced a fire sale of every other kind of asset, and, in the process, nearly ended the financial world as we knew it.

Deregulation had made bank runs, of a different sort, possible again. Yellen did get it somewhat though:

Lehmangeddon turned what might have been a mild recession and a milder recovery — think a worse 1991 — into the worst crisis in 80 years. So what should have been done in, say, 2005 to have avoided this disaster? Well, Yellen is almost certainly right: the Fed should have tried to regulate away, not prick, the housing bubble. Things like cracking down on liar loans, tightening loan-to-value requirements, and toughening leverage ratios probably would have slowed the bubble, and made any subsequent bust less of a financial cataclysm.

Paul Krugman then talks about what happened after the crisis (go read the article to see his supporting graphs):

For the most part, even those who correctly diagnosed a housing bubble failed to notice or at least to acknowledge the importance of the sharp rise in household debt that accompanied the bubble:

And I would argue that this debt overhang has held back spending even though financial markets are operating more or less normally again.

Finally, nobody really anticipated the disastrous response of policy, above all the squeeze on public spending at a time when we needed more government spending to sustain the economy until private balance sheets were repaired.

Luckily we didn’t have someone like Rand Paul in power who thinks we should have cut the federal budget and doesn’t seem to know that the deficit is now well under a trillion dollars and shrinking fast

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