Recently I had an interesting conversation with Martin Wolf of the Financial Times. We were discussing whether it was the Federal Reserve (Fed) or the saving glut from emerging markets that fueled the global liquidity glut in the early-to-mid 2000s. Martin Wolf argued it was the saving glut that was the important enabler and that the Fed's response was more or less an endogenous one. I, however, made the case that the Fed played an important role in creating the global liquidity glut given its monetary superpower status. By the end of the conversation our disagreements had narrowed, but one of the unresolved questions we ended on was whether the Fed could have acted differently given the political economy of the time. Here is Martin Wolf replying to me:
Yes, the Fed could have chosen otherwise, by a mixture of monetary and regulatory policies. I do not disagree. But to have done so would have meant a weaker recovery in domestic output. That might have been the right policy. But could it have got away with it? Who knows?So what do you think? Could this counterfactual have happened in the 2003-2005 period? As I have noted before, productivity and aggregate demand growth were robust during this time, suggesting tightening could have occurred without harming the recovery. On the other hand, employment growth was sluggish and the political push for increased home ownership would have made tightening politically challenging. Of course, the whole point of having an independent central bank is for moments like these, when tough calls have to be made.