A Note to the Financial Crisis Inquiry Commission

President Obama's Financial Crisis Inquiry Commission (FCIC) is under way and taking testimony from economists and other experts on what they believe were important contributors to the crisis. I was interested to see what was being said about the role U.S. monetary policy may have played in creating the crisis. Surprisingly, the only public testimony that looks closely at monetary policy's role is that of Pierre-Olivier Gourinchas.*His testimony amounts to two main points: (1) the conduct of the Fed in the early-to-mid 2000s was largely warranted given the threat of deflation and the weak employment growth then and (2) it was not so much a saving glut as it was an excess demand for safe debt instruments only available in the United States that caused excessive amounts of credit to be channeled to the U.S. economy. On both points there are alternative perspectives that paint a far less favorable view of U.S. monetary policy at the time. In case the FCIC is wondering, here are my own views on these two points:

(1) There is a good explanation for the deflationary pressures and the weak recovery in the labor market in the early-to-mid 2000s that does not justify the Fed's monetary policy at the time: strong productivity growth. Productivity growth accelerated for several years after the 2001 recession peaking in late 2003, early 2004. These rapid productivity gains were the cause of the deflationary pressure, not weak aggregate demand. In fact, by 2003 the aggregate demand growth rate was accelerating and reached about 6.5% growth in 2004. The rapid productivity gains most likely also account for much of the weak employment recovery that lasted through mid-2000s. Firms were not hiring as much labor in the recovery because less was immediately needed given the productivity surge. There is a significant empirical literature that shows productivity shocks typically lead to fewer hours worked in the short-run. Unfortunately, the Fed saw deflationary pressures and thought weak aggregate demand instead of productivity gains. It failed to make the important distinction between benign and malign deflationary pressures. [Update: For more on this distinction see here.]

Given the productivity growth-origin of both the deflationary pressures and weak employment recovery, the Fed's actions were not warranted at the time. Moreover, the Fed's response meant it was pushing real short-term interest rates into negative territory just as the rapid productivity gains were pushing up the neutral real interest rate. This interest rate disequilibrium was at the heart of the credit boom.

(2) The saving glut theory and the excess demand for safe debt instrument variation told by Gourinchas fails to acknowledge that some of the increase in excess saving from abroad is itself a result of U.S. monetary policy. As I wrote before:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

Guillermo Calvo makes a similar point. He argues that after 2002 it was fear of currency appreciation due to the Fed's easy monetary policy that drove the demand for U.S. assets, not excess foreign demand for safe debt instruments. Likewise, Maurice Obstfeld and Kenneth Rogoff argue that global savings in part had its origins with U.S. monetary policy:

We emphasize that this increase in global saving starting in 2004 plays out largely after the period Bernanke (2005) discussed in his “saving glut” speech, and arguably was triggered by factors including low policy interest rates. In our view, the dot-com crash along with its effects on investment demand, coupled with the resulting extended period of monetary ease, led to the low long-term real interest rates at the start of the 2000s. However, monetary ease itself helped set off the rise in world saving and the expanding global imbalances that emerged later in the decade. (p.22)

All of these authors and myself agree there were more factors in this crisis than just an overly accommodative U.S. monetary policy in the early-to-mid 2000s. However, monetary policy did play one of the more important roles and if the FCIC, policymakers, and the public conclude differently I fear we are doomed to repeat history.

*John B. Taylor submitted brief answers to a questionaire from the commission. His response, however, was not part of the public testimony.