Our problem, basically, is that we have a very distorted economy in the sense that there has been a significant recovery in a limited area of the economy amongst high-income individuals who have just had $800 billion added to their 401(k)s and are spending it and are carrying what consumption there is. Large banks, who are doing much better, and large corporations, whom you point out and the — and everyone’s pointing out, are in excellent shape.

The rest of the economy, small business, small banks, and a very significant amount of the labor force, which is in tragic unemployment, long-term unemployment, that is pulling the economy apart. The average of those two is what we are looking at, but they are fundamentally two separate types of economy.

Greenspan also argued for extending the Bush tax cuts for the highest-income families as well as the middle class, noting that the rich are the only ones spending, so best not to discourage them from doing so. That said, Greenspan said that eventually the Bush tax cuts should sunset. “I’m very much in favor of tax cuts, but not with borrowed money.” he argued. “And the problem that we’ve gotten into in recent years is spending programs with borrowed money, tax cuts with borrowed money, and at the end of the day, that proves disastrous.”

Additionally, he said he believed that very high unemployment will stick around for a long time. “I would say that there’s nothing out there that I can see which will alter the trend or the level of unemployment in this context,” he noted.

Here, Volcker — who criticizes the bill but says he ultimately supports it, and calls it an overall “B” — notes that real reform will depend on regulatory enforcement, and regulatory enforcement will depend on having good regulators.

“The success of this approach is going to be heavily dependent on how aggressively and intelligently it is implemented,” he says, emphasizing that a new, 10-member regulatory council authorized by the bill will have to be vigilant and tough to prevent the nation’s giant banks and investment houses from pulling America into yet another devastating credit crisis. “It is not just a question of defining what needs to be done, but carrying it out in practice, day by day, bank by bank.”

Second, he not-so-subtly criticizes Alan Greenspan, a free-market advocate and his successor at the Fed, under whom most deregulation happened.

His replacement, Alan Greenspan, openly campaigned to weaken and finally repeal Glass-Steagall, and President Bill Clinton signed the repeal into law in 1999. Although Mr. Volcker opposed the repeal, he didn’t go public with his concerns. “It is very difficult to take restrictive action when the economy and the financial markets seemed to be doing so well,” he says of his silence at the time. “But eventually things blew up.”

He also says he failed to anticipate just how wild things would become, post-Glass-Steagall: “Those were the days before credit-default swaps, derivatives, securitization. All of that changed the landscape, and now some adjustment must be made.”

[...]

In retrospect, Mr. Volcker regrets not challenging the widely held assumptions that underpinned much of this. “You had an intellectual conviction that you did not need much regulation — that the market could take care of itself,” he says. “I’m happy that illusion has been shattered.”

We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand.

Grim also notes that Greenspan wanted to keep the possible risks of a housing bubble “secret,” and that the Fed keeps its transcripts “secret” for six years. I say this from the viewpoint that Greenspan’s loose monetary policy wreaked unbelievable damage on the U.S. economy. But I agree mostly with Ryan Avent’s take on that particular quote. Here is a fuller version of what Greenspan said:

Let me first follow up on your transparency assessment. I think Cathy Minehan has raised an interesting point. I would say this: We run the risk, by laying out the pros and cons of a particular argument, of inducing people to join in on the debate, and in this regard it is possible to lose control of a process that only we fully understand. We have a ratchet in here where, if we were to move forward, we can’t go back. So the concept of transparency is a very important concept but one that should be approached with a recognition that we cannot move back and forth on it.

I’m a little concerned here that by raising certain issues we may not be able to backtrack. I hadn’t thought about it when I originally read the draft minutes, but in seeing the concerns that other people had, I think there’s something here that we have to consider. I do not recall so many people raising questions about the minutes before because I think most of us read the minutes passively. That suggests to me that, if there were really a strong focus on them, we’d find a greater degree of disagreement among us about their content. Now, I don’t know whether what I just said is true.

Greenspan is weighing in on a debate about Fed transparency — that is, how much the Fed wants to reveal about its thinking on inflationary pressures and monetary policy at that particular moment. He is not talking about whether to let the public in on whether there might be a housing bubble. (At that point, Fed economists had just started sounding the alarm. In June, the Fed started hiking the interest rate.) Greenspan was worrying that suddenly announcing real concerns about overheating might provoke an adverse response, particularly if things started cooling off by themselves. Avent explains:

Greenspan’s quotes are taken somewhat out of context. His comment is made, specifically, in the context of the phrasing of the Fed’s statement. Several presidents have remarked that the balance of threats to the economy is unpredictable, and the motion has been made that the statement change to reflect a balance of concern between upside (inflation) and downside risks, where before inflation was less of a concern than lingering economic weakness. And Greenspan is saying that with increased transparency, the Fed needs to be more careful about the language it uses lest it give markets whiplash by appearing to veer from one fear to another. Put more simply, if the language were to be changed in the March meeting and subsequent data revealed growth to be more of a worry than inflation (or something else) then the subsequent reversal would not generate a lot of confidence.

So the comment relates to the Fed’s public statements on monetary policy, which are as carefully worded as marriage proposals. Greenspan’s quote in isolation sounds horrible, but makes a bit of sense with more context. (Whether the Fed should be engaging in such elaborate minimalist kabuki in the first place? An entirely different question.) The misunderstanding and misreading of the rent ratio chart — where some of the country’s great economic minds sat around, bickering about what a chart of a basic macroeconomic statistic should look like and missing a bubble right in front of their faces — struck me as the more frightening part of the transcript.

In 2004, the Fed board discussed the possibility of a housing bubble intermittently, usually for just a few sentences at a time. But in June, it looked at a rent ratio graph and discussed it at length. Here it is, with the upper chart showing housing and the lower chart showing commercial real estate, and the red line the one to watch:

MS. BIES. I have a question on chart 3 on the commercial real estate valuation. Having lived through the 1986-91 period when the [net operating income]-price ratio was down to the levels it is today, I look at that period as abnormal because we had tax changes that were retroactive, which basically put a lot of real estate projects and ownership under water. So we had a tremendous upheaval in the real estate market, with people filing for bankruptcy and dumping properties. It worries me that we’re back down in a sense to a situation that is comparable to that severe turn in the real estate market. I really look at that as a good example of how retroactive taxes affect people’s return targets when they enter into long-lived projects.

MR. OLINER. I was actually here at the Board during that period, and I remember that we were concerned as well in the late ’80s about real estate valuations and the amount of construction still going on given that the tax benefits had been withdrawn in 1986. We did not really understand what the rationale was in the market. Ultimately it turned out that there was a massive amount of over-construction and lending standards that were too lax. I think there are some reasons to be watchful of developments in the commercial construction sector at this point. It is clear that the compensation for risk has gotten somewhat thinner in this market than it was throughout the 1990s, presumably after market participants had learned some lessons from the very thin compensation that they accepted through the ’80s. On the other hand, we do see some rather substantial differences in the structure of the commercial real estate market at this time. Lending standards do seem to have held much firmer. And there’s a lot more transparency in the market now because of the more widespread availability of data on prices and rents to market participants. So we think the decisionmaking is better. I wouldn’t say it is perfect. We do feel that there is some reason to be alert to developments in that market.

CHAIRMAN GREENSPAN. President Lacker.

MR. LACKER. Just to follow up on what Roger was asking about the panel in chart 3 on housing valuations. In that panel the relative movement of the two measures is somewhat key to at least the intuitive persuasiveness of the argument that housing might be overvalued. I understand the units of the real long-term Treasury yield. I don’t understand the units of the rent-to-price ratio.

MR. OLINER. The rent and the price data come from different sources; they are not part of an integrated system. The rent data are from the CPI, which is itself only an index number. So there is no way to say the rent-price ratio is 8 percent — like an earnings-price ratio, for example.

A quick note here. It is true that the data for renting and buying do come from different sources, but the rent ratio is hardly an obscure and unreliable statistic.

CHAIRMAN GREENSPAN. It is proportional to whatever that number would be.

MR. OLINER. Yes. We could make the level of the red line anything we wanted to, but we could only move it in a level adjustment up and down.

MR. LACKER. But you set the scale, too, right? You could set it so that the zeroes are the same on both axes?

MR. OLINER. Right. With creative charting we could make the relationship between the two series shift up and down however we wanted. That’s why we’re stressing –

CHAIRMAN GREENSPAN. But that’s not so for the ratio between those two series. That is invariant to the scale.

MR. LACKER. Yes, that’s true; they ought to have the same zeroes it seems.

CHAIRMAN GREENSPAN. No, no. If you have a relative measure that is an actual ratio, the ratio of the two numbers is invariant to what the relative number is.

MR. LACKER. That’s right. But in the chart, the staff has the zero set at very different places on the two scales.

CHAIRMAN GREENSPAN. You can’t trust them to do it right! [Laughter]

MR. LACKER. I’m just wondering, how did you decide where to put the zero? If you put it much closer to where the zero is for the long-run Treasury rate, the squiggles in the red line would be a lot smaller.

MR. OLINER. You can make the squiggles as small or as large as you want.

MR. LACKER. Right. And your argument has to do with the size of the squiggles?

MR. OLINER. No, I think the argument has to do with the size of the gap between the two. And the current gap relative to its average over history.

CHAIRMAN GREENSPAN. The scale will not change the fact that the gap is closing. The conclusion is independent of the scale. You could try any variation you want, and that gap will always close.

MR. LACKER. The gap between these two lines?

CHAIRMAN GREENSPAN. Yes.

MR. OLINER. No matter what we used for our charting convention, the gap would be relatively narrow now compared with its historical average.

CHAIRMAN GREENSPAN. Just take the ratio of the two ratios.

Confused? You should be.

The various Fed members are talking past one another about the construction of the graphs, rather than delving into their meaning. To be fair, the visuals are unusually constructed. The rent ratio is generally given — again — as the price of the home divided by the cost to rent it for a year. Their metric appears to be the annual cost of rental divided by the cost of the home. (Regardless, it shows a historical anomaly, with that red line on the upper graph suddenly diving.) Additionally, they chart their rent ratio against long-term Treasury yields, and spend more time discussing the relationship between the two than the anomaly of the rent ratio itself.

Were they to look at a simpler chart, it would be hard not to see something strange going on. Here is a standard rent ratio chart, which I took from Calculated Risk, with the yellow dot representing the time of the Fed meeting.

The anomalous upward shift is clear. And the Fed’s own economists noted it in a detailed note warning of a housing bubble just three months later.

Of course, hindsight is 20/20. The Fed governors in the minutes repeatedly point to good economic fundamentals stoking housing prices, rather than irrational exuberance, a credit bubble and the growth of real-estate flipping. But in this instance, the Fed willfully dismisses and misinterprets its own data. It reminds me of a passage from Carmen Reinhardt and Kenneth Rogoff’s “This Time It’s Different.”

The most significant hurdle in establishing an effective and credible early warning system … is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply.

Diane E. Thompson, a lawyer with the National Consumer Law Center, begs to differ. As part of the Federal Reserve’s Consumer Advisory Council, she and other consumer advocates alerted him to the looming crisis in mortgages starting in the early 2000s. We spoke earlier today; the interview transcribed below is lightly edited for length and clarity.

Greenspan’s testimony seemed to contradict even the Fed’s own reports on the housing bubble.

I was surprised to read what he said, because he articulated a view that’s been thoroughly discredited over the past several years. There was no meaningful regulation [in housing by the Fed] between 2000 and 2008. Statements were issued, but they weren’t binding — they were advisory and worked around the edges of the problem. Plus, there weren’t even any such statements during the height of the crisis! When things were gathering steam and hens were coming home to roost, the Fed did nothing. And it did nothing despite the fact that many consumer advocates were warning about loans in the subprime market. He says that he believed the sub-prime market was so small it wouldn’t matter to the broader economy. But obviously it did.

I also found it interesting that he said the problem was the demand for those loans. To some extent I agree with him. There was demand for these loans, of course, but had there been meaningful restrictions in place, this would not have become the crisis it did. The Fed finally put those restrictions into place in 2008.

The other point that struck me was his description of how involved the Fed was. He has cited the Consumer Advisory Council, but it was created by statute. The Consumer Advisory Council doesn’t exist by the good of the Fed’s heart. The years I served on it, it was dominated by industry. The Fed governors would say, “We have all these meetings with the Consumer Advisory Council! We get an interchange of views!” But my experience was that it was difficult to get consumers heard.

And the crisis was easier to see from the end-user, consumer side of it than the banking side?

The problem was obvious to those of us who worked in the communities where the housing bubble originated, particularly the African-American and Latino communities that were just obliterated by subprime lending. I think that there was this understanding that this was a minority-community problem — deplorable, but not exportable to the rest of the economy. That was wrong.

How often and how strongly did the Consumer Advisory Council warn the Fed about the housing bubble?

The council meets three times a year, and I was on it for three years, in 2003, 2004, and 2005. I know that during my time on it, as well as before me and after me, there were consumer advocates who said, “There are problems in the subprime market, and they could impact the entire mortgage market and the entire economy.“

That isn’t to say — I will not claim to have predicted the financial meltdown. To be honest, I was shocked, because I assumed that investment bankers had a better grasp of risk management. But, I know for years before I came on, and for years after I went off, at least from 2001 to 2007, at every meeting, people said, “There are problems in the subprime market. These policies aren’t promoting home ownership. If anything, they’re going to end up doing the opposite.”

I have heard statements from Greenspan in the past two years that seem to me more reflective of the role the Fed played and more cognizant of the fact the Fed missed signs of the crisis, which he did not say here.

What else surprised you in the testimony?

I was surprised at the attack on the GSEs [government-sponsored enterprises, Fannie Mae and Freddie Mac]. I was particularly surprised that he said that the banks weren’t the problem, but that the GSEs were. They got into the subprime boom late — and they aren’t what is driving the current foreclosure crisis. They contributed to the volume for some bad loans, but so did the large banks.

And so ultimately, as a consumer advocate…

There’s an assumption that runs throughout his testimony that these toxic products were in fact affordable products that increased home ownership. That continues to be a popular view among bankers. If you get rid of these toxic products you will reduce homeownership; these products help increase homeownership. That is contrary to all of my experience. There is just a weird tautology in saying there wasn’t a problem in the origination of the loans, but the demand for them.

There’s tremendous demand for cocaine — it would be like saying the issue isn’t the sale of cocaine, but the fact that there’s tremendous demand for cocaine. It is just bizarre. Can you imagine our drug enforcement focusing exclusively on drug users rather than drug dealers?

The Washington Post’s Dana Milbank today points out some of the more remarkable parts of Greenspan’s testimony:

“I warned of the consequences of this situation in testimony before the Senate banking committee in 2004,” he informed the commissioners Wednesday. “In 2002 I expressed concern . . . that our extraordinary housing boom, financed by very large increases in mortgage debt, cannot continue indefinitely.”

Milbank then contrasts that with Greenspan’s remarks before the Joint Economic Committee in 2005:

“A bubble in home prices for the nation as a whole does not appear likely.”

“Home price declines . . . were they to occur, likely would not have substantial macroeconomic implications.”

“Nationwide banking and widespread securitization of mortgages make it less likely that financial intermediation would be impaired.”

Perhaps we shouldn’t be surprised that the 84-year-old Greenspan — who was Fed chairman when Wall Street ramped up its interest in subprime loans, mortgage-backed securities, and a few of the other financial instruments that led to the collapse of the global economy — doesn’t want to be remembered as the guy who snoozed while the bubbles inflated. But neither should we let him rewrite history.

Yesterday, it heard from former Fed Chair Alan Greenspan. Today, the FCIC hears from former top Citi executives Chuck Prince and Robert Rubin, as well as the current and former comptrollers of the currency (responsible for regulating national banks); tomorrow, it hears from former Fannie Mae officials and Office of Federal Housing Enterprise Oversight executives.

What did Greenspan say of importance? Not much. (Here is a copy of his prepared remarks and a copy of his review of the boom and bust, titled “The Crisis,” prepared for the Brookings Institution and released last month.) Much of his testimony retread well-worn ground. But the “Maestro” did assert that he was correct 70 percent of the time during his Fed tenure. Angelides cannily asked him: “Would you put [the financial crisis] in the 30 percent category?” Greenspan replied, “I don’t know.”

He also said that banks had been undercapitalized for the past 40 to 50 years (a problem under the Fed’s purview) and argued that financial services might be too complicated for regulators to regulate. “It’s not a simple issue of, ‘Let’s regulate better. It’s a different world,” he said. “The complexity is awesome.” He hedged that statement by noting that banks’ counterparties — the firms on the other sides of their trades and loans — helped alert regulators.

You might get a feel for how consumer protection would be handled under the Fed.

We were curious: During the boom, did former Fed Chairman Alan Greenspan ever go to the meetings? Maybe rub elbows with consumer advocates who were sounding the alarms over high-rate subprime mortgages?

Our researcher, Rachel Hartman, got some limited info from the Fed. From 2000 to the end of his term in 2006, Greenspan never attended a single CAC meeting.

But, alas, the state protections were overruled by the Office of the Comptroller of the Currency, which gave national banks a pass and said they didn’t have to comply with those laws. And guess what happened next.

States that adopted tough anti-predatory lending laws had lower foreclosure rates than states without those laws, according to a new study conducted by the UNC Center for Community Capital.

In addition, after 2004, when the federal government exempted national banks from state anti-predatory lending laws, national banks increased their subprime lending the most in states with those laws. After this loophole opened in 2004, national banks made riskier loans, especially in states where other lenders remained subject to strict anti-predatory lending laws.

These conclusions suggest that when state laws did apply, the laws did a better job of promoting quality lending.

This study is a perfect reminder, as Congress and the administration tackle financial regulatory reform, that not all regulations are onerous, anti-business, and aimed at choking off financial innovation. And it’s more evidence that borrowers buying beyond their means weren’t the only only players in the subprime mess.

The same banks that found their way around these state anti-predatory laws are the ones getting government bailouts, and financial incentives to modify loans. And bonuses for top employees. The  study is an important reminder of their motives and behaviors during the housing boom, at a time when those same banks are lobbying against new reforms.