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?