Sunday, March 2, 2014

What Could the Fed Have Done Differently in 2008?

In my last post I showed that the second half of 2008 was when an ordinary recession got turned into the Great Recession. Starting about July, 2008 market sentiment began to significantly deteriorate as the economic outlook got markedly worse. Consequently, total dollar spending starts falling in July in anticipation of this economic weakening. Through two FOMC meetings the Fed did nothing and watched this development turn into a full-blown panic by mid-September. I noted that the Fed allowed this deterioration in expectations to occur by doing nothing. This failure to act, in turn, spawned the worse phase of the financial panic and the emergence of the Great Recession. By doing nothing, the Fed was doing something: passively tightening monetary policy at the worse time possible.

A number of observers have questioned me as to what the Fed could have done differently during this time. What difference would cutting the federal funds rate have made? 

As noted in my last post, the key was to change the expected path of monetary policy. That means far more than just changing the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time like the Fed did in 2003 and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten. So the correct response was about far more than just cutting the federal funds rate, it was about setting the proper expectations of the future path of policy and to stem the deteriorating economic outlook. 

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have never happened and the resulting bankruptcies been fewer. Again, the worst part of the financial crisis took place after this period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. Unlike the Great Depression, though, the Fed did eventually get aggressive with its QE programs so outcome was better. 

So yes, the Fed could have done a lot during this time. Because it did not act it spawned the Great Recession.

6 comments:

  1. Had the Fed done what you suggest what, in your view, would have happened to the private debt to GDP ratio? In particular, could they have prevented the recession without letting that ratio grow? If not, would there have been a risk that they might have been simply deferring the day of reckoning?

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    1. Nick:

      Great question. I am claiming that some portion of the asset price declines and defaults would never have happened had the Fed followed my advice. That is, not all of the collapse in private debt was necessarily fated to happen. Some of the private debt would have defaulted, but the rest was caused--or endogenous to--by the falling economic expectations that the Fed could have stabilized. As I noted in my original post, this latter part is the difference between an ordinary recession and the Great Recession.



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  3. David, simple O/T question on the long term neutrality of money formula. Setup: cashless society, time=t0, reserves = R, bank deposits = D, what is M(t0) = M0? I say M0=R. Now CB takes over banking at time=t1: result: reserves=0, bank deposits=0, CB-deposits (replacing bank deposits) = D. What is M1=M(t1)? I say M1=D. If P0=P(t0), what does P change to eventually? Call long term P, P1. I say P1=P0. No change. But the formula would say P1=P0*D/R. So we changed M, but P didn't change because a transfer of demand took place between money and non-money, thus invalidating the formula. So it seems the way in which M is changed makes a difference. Does all this sound right?

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  4. "was when an ordinary recession" << sorry David, while I agree with your policy that the Fed should have done more, the bubble in house prices and over-leveraged CDOs & MBS price drops created a homeowner equity wealth drop. This wealth loss was greater than the Depression change, but the unemployment only dropped, it didn't fully crater. Wealth usually changes so slowly that being in or out of any model is irrelevant (like tracking 02 in the atmosphere). No model that excludes the huge wealth changes from 1995-2000-2005/2006-2008 will explain the Great Recession.

    But because such wealth loss hasn't happened before, and won't happen again in our own lives, even a "correct" model won't be able to be tested again.

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    1. Tom, my argument is that a significant portion of the wealth drop was not inevitable. Instead, they were the result of the Fed's inaction. Again, I refer you to Gorton's claim that not all the CDOs and MBS were subprime.

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