Wednesday, November 11, 2015

Fact Checking the Fact Checkers

The fourth GOP debate was last night and the economy was an important part of the conversation. Much was said last night that deserves commentary, but I want to focus on one claim that really surprised me. It surprised me because it went against the standard GOP narrative about the Fed. So what was this claim and who said it?

The claim was that the Fed tightened monetary policy in the third quarter of 2008 and this tightening contributed to the Great Recession. This view implies the Fed should have done more to avert the crisis, both in late 2008 and afterwards. It came from none other than Senator Ted Cruz. Someone has done their homework. This is a subtle, but important point that many of us have been making for the past seven years. So kudos to Senator Ted Cruz for recognizing it. 

Sadly, some observers still miss this insight and this sometimes includes the fact checkers of the debate. The latest example of this is Isaac Arnsdorf of the Politico Wrongometer, which is supposed to "truth squad the Republican debate." Here is Arnsdorf's response to Cruz:
But what did the Fed do in 2008? It wasn't tightening money. The Fed actually cut rates repeatedly in 2008. Some economists have argued policy makers didn’t cut rates fast enough given the economic conditions. But that's only "tightening" if you measure it against the demand for liquidity and market expectations. It doesn't reflect the Fed's actual policy moves.
Someone is trying too hard here. Monetary policy can tighten even if the Fed does nothing. It is called a passive tightening of monetary policy. It occurs whenever the Fed passively allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in velocity. The damage done by a passive tightening is no different than that of an overt tightening. 

But don't take my word for it, just ask Ben Bernanke.  Back in late 2010, he acknowledged the possibility of passive tightening and used it as a justification for stabilizing the size of the Fed's balance sheet (my bold):
Any further weakening of the economy that resulted in lower longer-term interest rates and a still-faster pace of mortgage refinancing would likely lead in turn to an even more-rapid runoff of MBS from the Fed's balance sheet. Thus, a weakening of the economy might act indirectly to increase the pace of passive policy tightening--a perverse outcome. In response to these concerns, the FOMC agreed to stabilize the quantity of securities held by the Federal Reserve by re-investing payments...By agreeing to keep constant the size of the Federal Reserve's securities portfolio, the Committee avoided an undesirable passive tightening of policy that might otherwise have occurred...
In short, the FOMC was concerned that a failure by the Fed to reinvest its mortgage receipts, which would amount to a reduction in the monetary base, would be contractionary. So for the FOMC, a passive tightening of policy is just as serious as an active one.

Okay, let's apply this notion of passive tightening to the fall of 2008. As I have noted before, both inflation expectations and nominal demand had been falling since mid-2008. Normally such actions would would lead to an easing of monetary policy. But the Fed decided against easing in its August and September 2008 FOMC meetings. By doing nothing at these meetings it was passively tightening.

The September decision not to ease was especially egregious given that the collapse of the financial system was happening at the very same time. Note only did the Fed not ease, but it indicated it was just as worried about inflation as it was about the real economy. In other words, the Fed was signaling it was just as likely to tighten policy going forward as it was to ease. This was probably the worst forward guidance the Fed ever gave.

So Senator Ted Cruz was absolutely right. There was a major tightening of monetary in mid-to-late 2008. And in my view, it was this tightening and the failure to correct it later that turned what would have been an ordinary recession into the Great Recession. This may be a new insight for some observers. It should not, though, be a new insight for a fact checker criticizing a candidate.  

PS. Yes, Senator Ted Cruz did go on to advocate a gold standard. He is, however, interested in a rules-based approach and I suspect would be open to a NGDP level target based rules framework. So let's be gracious and acknowledge the big insight on Fed policy that Cruz alone noted last night. 

PPS. Dr. Ben Carson said he was a long-time friend of Janet Yellen and likes her. He also said he wants to see the dollar tied to something. May I suggest a market-driven NGDP futures contract?


  1. I still say that the Fed rate over 5% during 2007 was too high. It should have been below the growth rate of NGDP. The recession started at the end of 2007.
    Here is a Fred chart for it...

    By the middle of 2008, the economy began unraveling its deeper shenanigans. That is a different story.

  2. David, what do you make of this answer from Ben Carson on breaking up the banks:

    --- --- --- --- ---

    "Well, I think we should have policies that don’t allow them to just enlarge themselves at the expense of smaller entities. And certainly some of the policies, some of the monetary and Fed policies that we’re using makes it very easy for them, makes it very easy for the big corporations, quite frankly, at these very low interest rates to buy back their stock and to drive the price of that up artificially. Those are the kinds of things that led to the problem in the first place.

    And I think this all really gets back to this whole regulation issue which is creating a very abnormal situation. This country was — declared its independence in 1776. In less than 100 years, it was the number-one economic power in the world. And the reason was because we had an atmosphere that encouraged entrepreneurial risk- taking and capital investment. Those are the fuels that drive it.

    And what we’ve done now is let the creep of regulation turn into a stampede of regulations, which is involved in every aspect of our lives. If we can get that out, it makes a big difference. And even for the average person, every single regulation costs money. And it’s shifted to the individual.

    So — and it hurts the poor and the middle class much more than it does the rich. They go into the store and they buy a bar of soap, it costs 10 cents more, they notice it. And the middle class, when they come to the cash register, have a whole cart full of things that cost 5, 10 or 15 cents more, they notice it. It is hurting the poor."

    --- --- --- --- --- ---

    So David, do you agree?

  3. My general impression of the Republican field this year in fact is that they are close to declaring Milton Friedman a committed left-wing ideologue. I've never heard so much talk of "loose money" and bemoaning the inflation that's not there and the danger we're supposedly currently putting ourselves in by the Fed "goosing the economy" and the virtues of bringing back the gold standard.

    I'm afraid Milty would be branded a statist... perhaps even a communist in today's political environment on the right.

    If the right moves such that Milton Friedman is generally considered to be a socialist, free trade is considered anti-American (only benefiting the "donor class" ... a phrase I see more and more on right wing blogs), and liberal immigration policies are considered treasonous, then where does that leave the MM crowd? Time to start a new party? Maybe not a bad idea... a 3rd party could make temporary issue specific alliances with the other two parties to actually get something accomplished once in a while.

  4. Prof. Beckworth
    You have written about the fact that the Fed might have contributed to the "housing bubble" by having adopted a too easy money during 2003 and 2005. That implies higher than trend NGDP growth. Other market monetarists disagree, they say that in practice what Greenspan did was to implicitly adopt level targeting and therefore, the above average NGDP growth in 2006 and 2007 was justified. I understand that that was the worst timing possible for a switch to inflation targeting, because if the monetary authority was trying to keep nominal spending constant at a time that real growth was slowing, inflation would be higher than normal. We all know what Bernanke did, to bring inflation to target, he produced a recession that ended up being severe. Now, my point is, isn't this an argument against level targeting? If Greenspan in practice was doing just that, he ended up just creating more inflation, to a level that ended up being a little too much? I understand that level targeting is important because it manages expectations, but isn't there a side effect there somewhere, which is higher than acceptable inflation, a few periods down the road? Thanks!