Wednesday, January 27, 2016

Revisiting the Causes of the Great Recession

Ramesh Ponnuru and I have an Op-Ed in today's New York Times:
IT has become part of the accepted history of our time: The bursting of the housing bubble was the primary cause of a financial crisis, a sharp recession and prolonged slow growth. The story makes intuitive sense, since the economic crisis included a collapse in the prices of housing and related securities. The movie “The Big Short,” which is based on a book by Michael Lewis, takes this cause-and-effect relationship as a given. 
But there is an alternative story. In recent months, Senator Ted Cruz has become the most prominent politician to give voice to the theory that the Federal Reserve caused the crisis by tightening monetary policy in 2008. While Mr. Cruz (who is an old friend of one of the authors of this article) has been criticized for making this claim, he shouldn’t back down. He’s right, and our understanding of the great recession needs to be revised.
The crux of our story is that what would have been an ordinary recession got turned into the Great Recession because the Fed failed to do its job. Readers of this blog will be familiar with this argument. For those who are not here is a brief recap of the evidence supporting our claims. 

First, the Fed contained the fallout from housing crisis for almost two years. This can be seen in the three figures below. The first two figures show that even though housing peaked in early 2006, employment and personal income outside of housing-related sectors actually grew at a stable rate up until about early-to-mid 2008.
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This third figure shows that nominal spending overall continued to grow fairly stable during the initial run on the shadow banking system, as seen by the Ted spread. That run occurred from occurred from August 2007 to about May 2008. It also shows that the biggest spike in the Ted spread occurs only after the Fed allows nominal spending to start dropping.


Second, the Fed tightened policy in 2008 and did so in two phases. First, beginning around April 2008 the Fed began signalling it was planning to raise interest rates as seen in the figure below. It shows the market expectation of the federal funds rate one year in advance. It rises all the way through the summer of 2008 and remains higher than the actual federal funds rate through October 2008. This is the first phase of tightening in 2008. It was an explicit tightening, albeit of the future path of monetary policy.

 



The second stage, as we note, in the Op-Ed occurs in the second half of 2008. Here the natural interest rate is falling fast and the Fed fails to lower its target interest rate until October 2008. This is a passive tightening of monetary policy and is reflected in the decline in expected inflation and nominal spending that starts in mid-2008.







To summarize, our argument is that the Fed was doing a decent job responding to the housing bust up until 2008. After that point it tightened monetary policy and catalyzed the reaction that lead to the Great Recession. By the time the Fed changed course in late 2008 it was too late. Interest rates had already cross the zero lower bound (ZLB). Once that happens monetary policy as it is currently practiced cannot do much. (For more on the crossing of the ZLB see my review of Atif Mian and Amir Sufi's book on the crisis. Update: also see this twitter conversation with Amir Sufi on the ZLB.) The central bank of Australia, however, acted sooner and never faced the ZLB problem, despite having a housing and debt bubble too.

For interested readers, I would direct to the work of Richmond Fed economist Robert Hetzel who has written an article and book that makes the same argument.  Also, see Scott Sumner's early critique of Fed policy during this time as well. 


P.S. Just to demonstrate how worried the Fed was about inflation rather than growth late into the crisis, here is an excerpt from the minutes of the August 2008 FOMC meeting. Note they they were expecting to raise rates at the next meeting. 


60 comments:

  1. So it is finally revealed! We now know who leaked the monetary secrets to Cruz--or at least we know that it is likely "one of the authors of this article." Of course the odds are on Beckworth, given the Texas connection. Would you care to comment?

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  2. Update: there might have been some overlap between Ponnuru and Cruz at Princeton. Odds shifting...

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    1. Eric, yes Ramesh and Ted were friends at Princeton. That is the "old friend" part.

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  3. Great Article! I think this (and the related NYT article) is the clearest explanation I have seen of how Market Monetarists believe that non-optimal monetary policy led to the Great Recession.

    I have a question on:

    "By the time the Fed changed course in late 2008 it was too late. Interest rates had already cross the zero lower bound (ZLB). Once that happens monetary policy as it is currently practiced cannot do much.".

    Most Market Monetarists think that the ZLB is not a constraint on monetary policy and even after the recession had got underway (and the ZLB crossed) more appropriate monetary policy could have shortened it. I'm guessing that the "as currently practiced" clause means that you agree with this but think that as long as the fed uses interest rate as its main instrument then it really is constrained by ZLB.

    Is that a correct reading ?

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    1. Market Fiscalist, yes, you nailed it. Until the interest-rate targeting Fed finds a way to get around the ZLB (and is not afraid to tolerate temporary bouts of inflation above 2%) this problem will persist. You know my preferred solution!

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  4. "The Fed of 2008 feared inflation too much and recession too little."

    This should be changed to "The Fed fears inflation too much and recession too little."

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    1. Both Fed'08 and Fed'16 share the same bias but Fed'16 DOES seek a little inflation...desperately. In their saner moments, anyways.

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  5. Do you know of any good blog posts (yours included), papers, articles, etc. that explain why the housing market declined?

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    1. http://idiosyncraticwhisk.blogspot.com.au

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  6. Dave, congrats on your op-ed, and thanks for the complementary piece here with figures.

    A typo above:

    "the Fed was doing a descent job responding"

    should be

    "the Fed was doing a decent job responding"

    I think.

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  7. David, are Nominal GDP in graph 3 and Total Dollar Spending in graph 6 supposed to be the same? Levels on y-axis look different. I assume this is from Macro Advisers?

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    1. M.R., yes, one graph has billions and the other has trillions. But same relationship. And yes, it comes from Macro Advisors.

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    2. I just meant that one seems to peak around $14.5 trillion and the other around $15 trillion, unless my eyes are deceiving me. Anyway, the monthly series is a bit noisy. I sometimes think market monetarists overplay the spike in the Macro Advisers series in June '08 when arguing that the Sept. '08 events weren't a major cause of Great Recession.

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  8. David, you are too easy on the Fed. LIBOR was exploding in 2007. That was a red flag. The Fed had that data and should have opened the floodgates. Yes, LIBOR had not done damage, but it was headed toward major damage as it crossed the 10 year Swap line in early 2008 but was rising towards it for a full year. I don't get why that would have not caused a major concern since the 10 year swaps rate was diving all of 2007.

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    1. This would imply that every time in the preceding 60 years that happened, the Fed recognized the red flag, opened the floodgates in a timely fashion, and a Great Recession was averted. Am I missing something?

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    2. Well, it didn't happen this time in a vacuum, Tin. (Sorry for the metaphor!) People were walking away from homes and inventories were soaring. It was not a normal situation. You had to be a blind man to not see it by 2007. The Fed just doesn't care about the USA anymore. I believed that when I first started looking at the housing bubble and crash and I believe it more than ever. The Fed is a globalist organization.

      And 60 years ago, there were not many swaps. If you look at chart 2 here, you will see that the Swaps lin and LIBOR line had a fair bit of separation and when the LIBOR line rose and the Swaps line declined in 2001 and in 2007 , both resulted in recessions. When they crossed, we had the Great Recession. Banks bet on LIBOR. http://www.talkmarkets.com/content/us-markets/libor-destroyed-subprime-but-the-fed-deepened-the-great-recession?post=82947&page=2

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  9. On a slightly different subject, David, the Fed says it did IOR to keep banks from dropping the interest rate by loaning below the Fed Funds Rate. But it was never meant to increase lending by much. (NY FED). How important was that floor created so banks would not loan below the Fed Funds Rate?

    What could the Fed have done differently with IOR?

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    1. It could have done nothing with it, that is, left IOR at zero, which would have amounted to having an easier policy during the crucial period of which David speaks. The fed funds rate would have fallen below the Fed's--as it did anyway--the dip might have been temporary rather than permanent, as nominal income would have kept from declining so much, and might even have increased.

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    2. Thanks George. Certainly saving interbank lending did not have a stimulative effect much at all. Certainly, money policy was not behaving this way when WW2 started. Talk about juicing monetary policy! http://www.sjsu.edu/faculty/watkins/depmon.htm

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    3. The Fed feared that without 25bps of IOR, the interbank lending market would have completely frozen. Why would banks lend at 0 interest rates with the risk of not being paid back when you could keep your money and earn the same rate (0%)? If you accept this reasoning, then slightly higher IOR is actually looser money than no IOR given the circumstances.

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    4. So, Jared, the Fed should have bumped up the Fed Funds Rate and it could have increased bank lending, right? So, the Fed was sort of right but the MMers were more right.

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    5. No. According to this logic, a positive rate is required to create a market for INTERBANK lending. Any increase over that minimum market-making rate, would just make borrowing more expensive, and probably reduce demand. I wasn't talking about bank lending to non-banks, but the same logic applies: higher rates=less demand for loans, ceteris paribus.

      I thought it was the Neo-Fisherites who believed raising rates would increase lending, not MMers.

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    6. Less demand for loans unless the credit scores are lowered. When mortgages are cheap, high credit scores are often needed. When the rates go up a bit, banks lower their demands for pristine credit. So, it isn't always the rule that demand will soften when rates rise. Depends on the ease of qualification for the loan. Also, if the loan is adjustable, it needs to be able to adjust upward for it to "work". So rates can't be rock bottom for the use of adjustable loans. Many didn't work, but some did as people went to multigenerational living to save houses.

      Can't speak for the MMers on that. It is just my observation living in Nevada.

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    7. Jared, wish I could edit and add this to the last post. Interbank lending bumped up for a time after it cratered due to excess reserve interest paid to the TBTF banks, and then just vanished. If you extend George Selgin's chart out to current time, interbank lending has gone away, so banks use excess reserves to settle and the Fed as well. So, that can't stimulate banks to lend much, IMO. The Fed wants slow growth. The MMers want boom. The Fed won't allow boom. I am just guessing, but boom would possibly allow the long bond to rise in yield, meaning all that collateral in the derivatives market would have to be augmented by more treasury bonds. I just think the Fed has bet on pretty low rates and slow growth at the same time.

      Look at Japan. Lowered interest rates to negative and Japanese treasury bonds went up in value. I wonder what those bonds are used for. Collateral? If so, you could go negative to infinity. Not sure about that but it is an unsettling thought.

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  10. Old but provides same arguments
    https://thefaintofheart.wordpress.com/2011/04/14/the-crisis-from-an-ad-perspective/

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  11. I liked your article, but if your goal was to convince the readership of the NY Times, you certainly did not convince any of their commenters. These ideas are so important for everyone to understand no matter their political affiliation that I would hope going forward you would bend over backwards to get past people's partisan defenses and make clear this is not a right-wing ploy to end bank regulation.

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    1. I'm talking about discussions in mass media, BTW, not demanding you defend yourself on your own blog.

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    2. You can't convince them of that while invoking the name of Ted Cruz. He is such a flake on non political issues, that he will never get elected president, no matter how astute he is on this matter. He has a Goldman Sachs wife, and no one believes he is a maverick, even though he fancies himself a maverick, shutting down government, probably to make money for Goldman Sachs. JMO. And there are no real mavericks anymore in the globalist controlled political system.

      The Fed destroyed interbank lending in order to save it. That will always be their argument against the Market Monetarists.

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  12. Great article and post.
    My only quibble is that I do not think the housing market was ever over-supplied with housing, though perhaps a few regions were aggressively built.

    Kevin Erdmann's work on housing markets and property zoning is very informative.

    My new motto: print more money and build more housing.

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  13. Your theory is that it was Fed tightening and not the collapse of the housing bubble that caused the Great Recession. The trouble with this theory is that the facts don't confirm it.

    Everyone agrees that it was the severe tightening by the Fed that caused the Volcker recessions. And yet as soon as the Fed ended its tight money policies the economy roared back. If your theory is correct, why is it that seven years after the tightening by the Fed and after an extended bout of loosening the economy is not only just about limping along, but shows signs of falling into recession?

    The truth is that it is impossible to understand the Great Recession without examining the accompanying asset market crashes, just as it is impossible to understand the Great Depression or Japan's "Lost Decade" without examining the asset market crashes that accompanied them.

    The monetary tightening that caused both the housing crash and the Great Recession began in 2006, as the graph on http://www.philipji.com/item/2015-12-05/the-fed-is-set-to-squeeze-during-a-monetary-contraction shows. If the recovery from the Great Recession has been so long-drawn-out it is because the median US household lost 18 years of net worth in the crash, and has been curtailing its expenditure ever since in a bid to recover that lost net worth.

    The sad part, as the graph above shows, is that we have been in an almost identical bout of monetary tightening since the start of 2014. The fall in commodity indices and then in the stock market indices is just a reflection of that. But monetary tightening alone will not cause prolonged morbidity unless a bubble, that has been created before, explodes.

    For those interested, my book "Macroeconomics Redefined" http://www.amazon.com/dp/B00ZX9O5XQ explains the main problems in contemporary macroeconomics, beginning with an inability to understand money.

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    1. Philip, so glad you settled everything!

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    2. Philip, from a non economist viewpoint, I believe the Fed both started the housing bubble by mispricing MBSs, and then took it down by tightening starting in 2006 as you say. I don't think you are far off the MMers, as Kevin Erdmann said the Fed took the economy down. The Fed pumps and dumps the economy, and that is sort of a fraud. The MMers believe that those lows don't need to happen. But what if the Fed wants them to happen? I think that is the case, unfortunately. But if anyone has a better explanation I would like to hear it.

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    3. Phillip, it's almost as if you didn't read the post or the accompanying article published in the NYT. The point is that the Fed can sustain NGDP despite very real trouble in asset markets. And doing so will substantially limit lost net worth, as well as future income, and thereby mitigate the negative outcomes that you point out (i.e., increased demand for money).

      Also, "after an extended bout of loosening"?? what are you referring to? Fed tightening was by no means a one-and-done affair. Policy has been tight since the beginning of the recession with no end in sight.


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  14. David, I agree the Fed didn't do enough to save the economy, but you seem to have an unusual conception of causation. No one would say the fire department CAUSED a house fire because it didn't bring enough trucks to fight a huge blaze. The facts, even as you lay them out, demonstrate the housing market created a dire situation that required a significant response from the Fed (more fire trucks than usual). In fact, your chart above showing the decrease in the Fed Funds Rate from Jan. - May 2008 was the sharpest decrease since 1984 (https://research.stlouisfed.org/fred2/series/DFEDTAR). So the Fed eased policy more aggressively than it had in almost 25 yrs (it brought more trucks than usual). The fact that it wasn't aggressive enough shows that something in the economy was dreadfully wrong... and that was the housing market and the financial system's exposure to it, especially the unregulated, shadow portion of it.

    Furthermore, you say "what would have been an ordinary recession got turned into the Great Recession because the Fed failed to do its job." Yet, the only way this would have been an ordinary recession is if the Fed had taken unprecedented easing measures. It certainly wasn't the case that business as usual would have prevented the Great Recession. Again, I agree the Fed didn't do enough, but failing to save the day with heroic efforts is not the same as causing the crisis. Especially when most of the loudest voices are yelling at you to do the opposite.

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    1. The Fed is (should be?) a control system. It looks at current conditions, and sets its dial to achieve its targets. It's a thermostat, connected to an infinitely powerful furnace and AC. Yes, maybe there was a colder than usual winter storm outside. But if the house is too cold, and the Fed has CHOSEN not to turn on its infinitely powerful furnace ... well, it seems appropriate to blame the Fed for making a stupid choice.

      The housing / financial roots of the crisis may indeed have been stronger than usual. The required easing may have been "unprecendented". What about this makes appropriate action "heroic"? It's their explicit job, and they possess a sufficient toolkit. How can you be comfortable, allowing the Fed to escape blame for their failure?

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    2. I didn't say the Fed should escape all blame. There is a difference between accepting the blame of failing to rescue a falling economy and being the cause of the fall. I was arguing against the latter.

      However, if the Fed would have done what Beckworth suggests, it would have been "heroic" in the sense that the FOMC would have taken unprecedented action (to lower interest rates at a faster pace then ever before AND to lower them to zero BEFORE an actual panic occurred) while most of the experts would have been screaming that they were failing to do their "explicit job" (stabilize prices). They would have rescued us from the coldest weather seen in 80 years, by stepping out on a very long limb.

      But I don't believe they could have forestalled a severe recession in 2008. By blaming the Fed the way you do, you're criticizing an institution for not being omnipotent. The notion that the Fed has an "infinitely powerful furnace" is just wishful thinking. Beckworth's model is all about signals and expectations. The problem with signals is they're ambiguous. Any doubt, miscommunication, or irrationality impairs the power of the furnace.

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    3. In 2008, NGDP growth fell 10% below its trend line, and NEVER recovered: https://oregoneconomicanalysis.files.wordpress.com/2011/10/ngdp_trend1.jpg

      Can you be more explicit about why exactly you believe the Fed had no ability to maintain the NGDP trend? And the communication signal is trivial: simply announce "we will continue to expand the money supply -- perhaps at exponentially increasing rates -- until NGDP returns to the target trend." What's so confusing about that? What's so hard to implement?

      The communications solution is NGDPLT: a level target, to credibly promise to make up for any past mistakes. And an NGDP growth target, to easily predict the value of money into the distant future.

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    4. It's certainly not that simple. For that to have worked in 2008, the Fed would have had to convince markets the increase in the monetary base was permanent. For such a promise to be credible, the Fed would have had to eradicate all inflation hawks, like Fisher and Lacker (http://blogs.wsj.com/economics/2008/04/17/as-rate-cuts-loom-but-inflation-hawks-strike-back/), from any influence over future policy. If any of them, or any hard money member of Congress, made a peep, the markets would have every reason to doubt the permanency of the increase in the monetary base. It's really difficult to make credible promises about the future, especially unpopular, heterodox, promises. What may work in theory, has a lot of messy real world obstacles to overcome.

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    5. I agree with you Jared! But notice that you're describing political obstacles, not economic ones. Fisher and Lacker were in power! They had votes! What I'm looking for is: (1) acknowledge that GOOD monetary policy would and could have essentially eliminated the economic pain of the recession, and thus (2) correctly blame the Fed leadership in 2008 for making horrible decisions.

      You are absolutely right, that Fisher and Lacker would have prevented the proper (more accommodating) monetary policy that was needed. We should hold them accountable for their decision-making failure, blame them directly, and force them to resign in disgrace for their errors.

      Right now, the Fed never admits error or responsibility. (At least, for bad outcomes. Good outcomes, they take credit for. Bad outcomes are never their fault.) This is mistaken. They ought to have explicit goals, and they ought to be held accountable for their performance. If they fail to achieve their goals, they need to accept responsibility and resign or be fired.

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    6. Don, I think you have a basic error in the belief that "The Fed is ... a thermostat, connected to an infinitely powerful furnace and AC." The proper metaphor would have an infinitely powerful AC and a rather anemic space heater.

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    7. Tin, it's clear that you and I disagree, but who has the error is a little more ambiguous. You are trying to assert that a central bank with unlimited ability to print fiat currency, is somehow unable to debase the value of that currency? Do you have any evidence -- theoretical or empirical -- for what mysterious force would stop a fiat currency central bank from causing hyperinflation, if it so wished?

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    8. Don, yes! I think we have found common ground. I agree the obstacles are political, not economic, but I think we still have some differences, albeit some may be more semantic than substantive. In response to your 1), which also serves as an answer to your question to Tin, the only way an NGDPLT can be credible, is if the central bank has the authority to purchase a wide array of assets. Currently, the Fed only has the authority to buy US Treasury debt and agency MBS. This may not be enough to keep NDGPL on target. Admittedly, this is just another political constraint. But once you expand the assets acceptable on a central bank's balance sheet, you're really blurring the distinction between "monetary" policy and "fiscal" policy. I would be more inclined to call a gov't purchase of a financial stock or real property fiscal policy, regardless of the agency making the purchase. But this is just semantics. I would agree that if the central bank were given the authority to buy whatever they needed to hit their NGDPL target, then monetary/fiscal policy could avoid most recessions (although not the pain as you say; there would still be many communities hard hit by foreclosures) and create hyperinflation at will. But I'm not sure I would want to give the central bank this authority (for political reasons).

      For your 2), you admit their were political constraints limiting the efficacy of monetary policy in 2008. These constraints were outside the control of Bernanke. Therefore, it's hard for me to assign the majority of blame on him or even the institution itself. Yes, I want to blame the Fishers and Lackers, but the list of their ilk is a lot longer than those two names, and that list includes persons outside the Fed, who nonetheless wield influence on policy decisions.

      In summary, given the institutional limitations existing in 2008, the monetary policy options available to Bernanke were not capable of stopping the impending recession. Therefore, he and the FOMC cannot be held as the main source of blame for the recession. Maybe we can alter institutional arrangements in such a way that we will have the power to stop future recessions, but it will involve economic and political change.

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    9. Ah, here's a good list of those other names I alluded to above, not even including Rick Perry. Again, I find it really hard to blame Bernanke and the Fed for not doing enough in a context such as this*.

      http://economics21.org/commentary/e21s-open-letter-ben-bernanke

      *This letter was written in 2010, but I think it's fairly safe to assume Bernanke would have faced similar, if not more hostile, pressures if he had begun large-scale asset purchases in mid-2008.

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    10. Jared, yes the overall soft constraints included confused but powerful non-economists in politics, and in fact the consensus of the overall macroeconomic profession (as suggested by the open letter you linked to). All these people were wrong, and the Fed in fact had sufficient power to prevent the recession, but chose not to use it. You should think of the NYT op-ed that is the subject of this blog post, as an attempt to inject some solid economic reasoning into the consensus of policymakers and macroeconomists, so that in a future crisis the Fed will actually do the right thing, instead of the wrong thing.

      As for NGDPLT, it is tempting to broaden the scope of possible assets that could be purchased. I agree with you, that Treasury bonds are the best asset in the world to buy (fewest distortions), and as you get farther way, the lines between fiscal and monetary policy start to blur. The good news, however, is that Market Monetarists (and I) strongly believe that no such additional authority would be required. The secondary Treasury market is sufficiently deep and liquid to supply all the assets that the Fed would need.

      Part of the difference may be that you are thinking of "concrete steps", where if a little bit of Fed purchases have a little effect, then to get a great effect you need a proportionally larger amount of purchases. But monetary policy actually works mostly through expectations, not through concrete steps. You need a concrete threat, but you don't need to actually carry out the purchases. In fact, if the Fed had credibly promised to and in fact did keep NGDP growing on its 5% trend, the demand for money (and thus the needed size of the monetary base), would have been far, far less than it is today. The base is large, BECAUSE the growth is so slow. Higher growth does NOT mean an even higher monetary base.

      You may enjoy reading Nick Rowe's classic post about "concrete steppes": http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/10/engdp-level-path-targeting-for-the-people-of-the-concrete-steppes-.html

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    11. Jared: Here's another way to think about it. The Fed claims to be targeting 2% annual inflation, but in the last decade has frequently fallen short of its goal. If you really think the Fed could monetize the entire $18T national debt, and still fail to raise inflation to 2% ... well, then forget about monetary policy. That's just a free lunch. You would be claiming that the country could retire its entire national debt with no consequence, never have to pay off 50 years of regular national borrowing. That would be great news!

      Of course, it's almost certainly false. Inflation (and thus NGDP) would rise long before the Fed got to the end of possible Treasuries it could buy. (And of course there's another $7T in MBS debt, which the Fed is also already authorized to buy.)

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    12. I re-read Rowe's post (I can't believe it's been over 4 years since he wrote that). As a methodological device, I never liked the "concrete steppes" criticism. It always just seemed like hand waiving to me. But Rowe's post is so good because he does describe the mechanism (the steppes) by which expectations can work. But now I have a question.

      Assuming the Fed needs to establish credibility to get off the ground with a new NGDPL target, it will conduct an increasing rate of asset purchases until it hits it target. Rowe then says, "The Fed only has to carry out its threat until people catch on to what's happening. Then it has to reverse course and sell all the assets it bought, and then some more, to prevent the economy overshooting the new equilibrium." At this point my question is, what happens to the Federal Funds rate during all of this? Does it even matter? I assume it had been kept at zero (with no IOR) until the Fed needs to reverse course, but then what?

      My worry is, in order to reverse course, the Fed will need to raise rates above zero. But since there's been a period of asset purchases, there will be a substantial amount of excess reserves sitting on bank's balance sheets. In such a case, the only way to raise the FFR will be to pay IOR to function as a floor at the level of the desired FFR. But according to MMers, IOR neutralizes the money stock.

      In essence, I'm concerned there's no way to establish your desired expectations because there's no way around paying IOR once excess reserves are introduced into the system. Well, on second thought, there's one way to establish your desired expectations, but that's only if the Fed promises never to pay IOR, which means rates would stay at zero even as NGDPL flies past its target. Therefore, an NGDPL target can only work if the Fed is willing to stomach a period of high inflation at any level, and markets believe that threat.

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    13. Don, The "printing of fiat money" is a fiscal/Treasury function, not the Fed's. The Fed makes loans available to member banks (and pays interest on deposits from them) at arbitrary rates. They also been known to purchase assets under extraordinary circumstances (i.e. QE) and presumably liquidate them (although they've indicated their preference to hold the bonds acquired under QE to maturity). I perceive the QE process to be a fairly ineffective "space heater" for the economy compared to direct payments from the Treasury.

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    14. Tin: No, sorry, you're not correct. The Treasury does print physical currency, but only in exchange for deposits. No fiscal/Treasury action changes the size of the monetary base. Only Fed actions affect the monetary base size. The phrase "printing of fiat money" does not refer to the physical creation of currency; it refers to enlarging the monetary base. Only the Fed does that, not the Treasury.

      The Fed has a dual role: it regulates the banks, and it runs monetary policy. These used to be more tightly connected, but under modern fiat money they are so separate that they really ought to be split into two different bureaucracies. In any case, making loans to banks has essentially nothing to do with monetary policy.

      You are not correct, with your implication that the Fed purchases assets only "under extraordinary circumstances". In contrast, Fed purchases of Treasury bonds has been a regular action for at least decades. That is the primary mechanism by which the Fed adjusts the money supply, which in turn is the primary tool to enact monetary policy.

      Your opinion about QE is not well-informed, but there isn't space here to get into the details. In contrast, "direct payments from the Treasury" have no effect on the monetary base, and thus no effect on monetary policy. (Fiscal policy can effect the supply side of the economy, but not the demand side.)

      I'm afraid you're pretty much wrong about everything.

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  15. Hi David,

    Very interesting post. I really like what you are trying to do with the one-year ahead federal funds rate, but I think your graph is consistent with the market continuously expecting easier policy as 2008 passed. (I'm not saying the chart proves my interpretation is right, I'm rather saying it could go either way; I don't think there is enough information.)

    Where did you get that data, so that if I try to show what I mean, I am using the same numbers as you?

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    1. Bob, I am not sure what you mean. If it is June 2008 and the current fed funds rate is 2% and the fed fund futures contract says it will be 3.5% in June 2009 there is really isn't much room for interpretation here. The market expects it to go up from 2% to 3.5% next year.

      The data is not easily accessible. You need access to a Bloomberg terminal to get it.

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    2. Hey David would love to get your view on this proposal of mine...I think I might have discovered a way to prevent regulatory capture of a regulator.The idea is simple. Start with the assumption that regulatory capture will happen and nothing you do will prevent it from happening.Then you divide the regulator into three independent wings, like the Legislative, Executive and Judiciary. Have three wings which can act as check and balances to each other. The Holy Trinity. Example in Auto Industry there are three chief regulatory captures.Industry,Workers and Consumers.Let the wings have representatives from each sector. Then we let the Coase theorem come into play, i.e. let the parties bargain with each other and you will get a more efficient result.At the end of the day, the issue is of bargaining,and you cannot capture that that information in a model,because it is in a constant state of flux.Example: when the oil prices were 120$ the bargaining would be very different when the price of oil is 30$.The consumer would be willing to pay higher taxes if the price of oil is going to go down,ask for better,safer cars at cheaper prices etc. The worker will be asking for higher wages as the cost of owning and making a vehicle around the currant market price is lower, hence greater profits,have better bargaining on their protections etc. The Industry would like to maximize the profits of shareholders, want better labor mobility, hire and fire laws,competition, trade, protectionism etc.The Government should not exist in the three mechanisms, not because of any libertarian reasons, but because even if a single team gets it, bargaining becomes asymmetric and the "game" is over.Imagine it as a game with three teams. The Government will at most have the power of a referee in a soccer match or an umpire in a cricket match.

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  16. Hi David,

    Yes I agree there are various possible meanings to the statement. But here's what I mean: Suppose in June 2007 the 24-month fed futures contract predicts 3.5%. Then a year passes, and by June 2008 the 12-month futures contract is still at 3.5%.

    Yes, you can say "In mid-2008 the market predicted a tightening of Fed policy over the coming year," but that tightening would have been predicted a year beforehand. It doesn't explain why everything was fine and then the markets screamed bloody murder in late summer / fall of 2008.

    And it also would be inconsistent with Ted Cruz's grilling of Yellen. He definitely was saying that the Fed changed people's expectations about what it was going to do, with its announcements through the summer of 2008.

    So do you agree that for the Ted Cruz / Market Monetarist story to make sense, the futures markets would have to show a tightening (measured as rising fed funds rate) relative to the previous path?

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  17. Hey David would love to get your view on this proposal of mine...I think I might have discovered a way to prevent regulatory capture of a regulator.The idea is simple. Start with the assumption that regulatory capture will happen and nothing you do will prevent it from happening.Then you divide the regulator into three independent wings, like the Legislative, Executive and Judiciary. Have three wings which can act as check and balances to each other. The Holy Trinity. Example in Auto Industry there are three chief regulatory captures.Industry,Workers and Consumers.Let the wings have representatives from each sector. Then we let the Coase theorem come into play, i.e. let the parties bargain with each other and you will get a more efficient result.At the end of the day, the issue is of bargaining,and you cannot capture that that information in a model,because it is in a constant state of flux.Example: when the oil prices were 120$ the bargaining would be very different when the price of oil is 30$.The consumer would be willing to pay higher taxes if the price of oil is going to go down,ask for better,safer cars at cheaper prices etc. The worker will be asking for higher wages as the cost of owning and making a vehicle around the currant market price is lower, hence greater profits,have better bargaining on their protections etc. The Industry would like to maximize the profits of shareholders, want better labor mobility, hire and fire laws,competition, trade, protectionism etc.The Government should not exist in the three mechanisms, not because of any libertarian reasons, but because even if a single team gets it, bargaining becomes asymmetric and the "game" is over.Imagine it as a game with three teams. The Government will at most have the power of a referee in a soccer match or an umpire in a cricket match.

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  18. Durations and Standards of "Tightness"

    http://newarthurianeconomics.blogspot.com/2016/02/durations-and-standards-of-tightness.html

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  19. The Arthurian: the size of the monetary base is not a reliable indicator of the stance of monetary policy. Friedman had proposed a k-percent rule in the 1960's. It was unsuccessful, because velocity is not as stable as Friedman hoped. As in any market, whether an item (in this case, money) is "tight" or "loose" depends as much on demand, as it does on supply. You need to track something like inflation (expectations) or NGDP (expectations) in order to determine whether money is tight or loose, not just the size of the monetary base.

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    1. Don: "the size of the monetary base is not a reliable indicator of the stance of monetary policy... You need to track something like inflation (expectations) or NGDP (expectations) in order to determine whether money is tight or loose ..."

      David Beckworth writes about interest rates:
      "beginning around April 2008 the Fed began signalling it was planning to raise interest rates"
      and then
      "the natural interest rate is falling fast and the Fed fails to lower its target interest rate until October 2008."

      Are you saying that changes in the size of the monetary base are not a consequence of changes in the interest rate target? Are you saying that changes in the size of the monetary base are not a "marginal" indication of whether money is tight or loose?

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    2. The Arthurian: Yes, that's essentially correct. Changes in the monetary base are indeed the tool that the central bank uses, in order to reach its interest rate target. But the "size of the monetary base" is a consequence of both the interest rate target, and also the current demand for money. So, yes, if all you have is the size of the monetary base, and you don't have any information about what is happening to money demand, then you know very little about whether money is tight or loose.

      Maybe it would help to think of it like this: it's absolute levels, vs. relative directions. The base getting larger does indeed mean that money is "looser" than it (counterfactually) otherwise would have been (and vis versa). But whether money is absolutely "loose" or not (rather than merely "looser") requires also knowing what is happening to money demand. In particular, whether money this month is looser than it was last month, cannot be determined by merely looking at the monetary base (or even at the nominal interest rate).

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    3. Thanks Don, pretty interesting.

      But are there numbers for NGDP expectations that I can look at on a graph? Or for inflation expectations -- maybe FRED's MICH? And are there numbers for the 'natural rate of interest'? Got links to anybody who has actually looked at such numbers?

      Numbers, as opposed to words, you know?

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    4. The Arthurian: Those are excellent questions, and the Market Monetarists think it is a national tragedy that the Fed doesn't create and subsidize an NGDP futures market, given how significant it is for monetary policy. So at best we can infer reasonable guesses.

      One obvious place to look, is actual published inflation and NGDP. That's not quite future expectations, but if you look back in the past at what actually happened (and if you're trying to analyze an historical event), you can hope that the expectations somewhat prior to the actual events, were at least in the ballpark of being accurate.

      Another good place to get estimates, is TIPS spreads. In a lucky break, the Treasury offers both regular nominal bonds (which return fixed interest payments), as well as "inflation protected" bonds, which return payments that vary depending on what inflation winds up being. The bonds are otherwise identical. The difference in current market price between the two types of bonds, is a good indication of the market's prediction for future inflation.

      There are some toy prediction markets (Hypermind is running a tiny NGDP one) that give a little data, but they are thinly traded now, and not especially accurate.

      This lack of critical data, for such an important economic problem as the current stance of monetary policy, is really a shame. I agree with you, that these kinds of numbers need to be MUCH easier to find.

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