The WSJ is effectively covering up for the Fed and the economics profession by implying that there was something difficult about recognizing the 70 percent jump in real house prices as a bubble or realizing that its collapse would lead to serious economic damage. The bubble was not difficult to spot for any serious analyst of the economy. The run-up was a sharp divergence from a 100-year long-trend that could not be explained by any change in the fundamentals of the housing market. It also was not accompanied by any notable increase in rents. It also should have been evident that the bursting of the bubble would devastate the economy. This article wrongly focuses on the financial aspects of the collapse. While this is important for Wall Street, the real aspects are far more important for the economy. The bubble added more than 3 percentage points to GDP in the form of excess housing construction and another 4 percentage points of GDP in the form of excess consumption driven by bubble generated housing wealth. This demand was absolutely certain to disappear when the bubble burst. The Fed has no mechanism that can readily replace a drop in annual demand equal to 7 percent of GDP or more than $1 trillion. (The downturn was exacerbated by the collapse of a bubble in non-residential real estate which is still in process.) This is all very simple. None of this requires complex economic analysis, just competent economists. It is also worth noting that the WSJ refuses to discuss what could be one of the Fed's most important tools against an asset bubble: talk. If the Fed had devoted its enormous research capacities to documenting the existence of a bubble and the likely implications of its bursting, and the Fed chairman used his enormous megaphone to widely disseminate this information at congressional testimonies and other public appearances, it would have almost certainly been sufficient to burst the housing bubble. While economists question this possibility, since the cost is trivial (talk is cheap), there is no excuse for the Fed not following this route in addition to whatever other measures it may take.
--Dean Baker