Monday, February 8, 2016

Responding to Our Critics

Ramesh Ponnuru and I respond to the critics of our New York Times op-ed over at Bloomberg View:
Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust...
Since some criticisms were directed at arguments we didn’t actually make, we should clarify a few things.

First, we are not saying that the right Fed policy would have kept any recession from happening. As we noted, the recession began in December 2007...Our argument, rather, is that [the Fed's] mistakes turned what could have been a mild recession into a “great" one.

Second, we aren't saying that better Fed policy could have prevented serious financial turmoil. Again, we explicitly note that financial stress began before the Fed’s worst errors. Our argument is the errors made that stress much worse.  
Please read the whole article. I would encourage interested readers to also see my follow-up post to the New York Times op-ed where I provide some empirical support for our claims. 

A key point we make in our Bloomberg View piece is that is one has to be careful in assessing the stance of monetary policy. Just because the Fed cut rates seven times from a high of 5.25% in September 2007 to 2.00% in April 2008 does not mean monetary policy was accommodative or even neutral. If that were that simple then the Fed would have been easy during the Great Depression when it cut its then policy rate, the discount rate, from 6.00% in October 1929 to a low 1.50% in July 1931. But almost no one believes that now. The Fed is seen as keeping monetary policy tight through the depths of the Great Depression. 

To really know the stance of monetary policy, one needs to know the market-clearing or 'natural' interest rate. If the Fed is not cutting rates as fast as the natural interest rate is falling, then, monetary policy is actually tight. This is not a controversial point. It is standard macroeconomics.

Even Atif Mian and Amir Sufi in their book “House of Debt” acknowledge this point in their discussion of the zero lower bound (ZLB). They acknowledge that if the Fed had been able to continue cutting rates pass 0% then it could have prevented the Great Recession. But don’t take my word for it, go read chapter four of their book or see this twitter conversation. Paul Krugman has similarly pointed to the ZLB as the true culprit for crisis and past seven years of sluggish growth. The point is that the Great Recession was not  inevitable had interest rates being allowed to reach their market-clearing level.

The only difference between Mian-Sufi-Krugman and us is that we believe the Fed had a chance to reach the market-clearing level of interest rates before it crossed the ZLB. We believe they had that chance through part of 2008. Had the Fed been less anxious about inflation and more aggressive in signalling it would do whatever is takes to keep economy stable the natural interest rate would have fallen far less--maybe even stabilized--making the ZLB less of a problem in the first place.

Instead, the Fed signaled during the first half of 2008 it was actually going to raise interest rates. The fear of a rate hike grew during this period, with fed fund futures rate for the 12-months ahead contract going from about 2.0 % in March  to almost 3.5% in June of 2008. Given that the natural interest rate had sharply fallen by this point, this means there was sizable gap between where interest rates needed to be and where they were expected to go. That means the Fed was strangling the already weakened economy. This only further depressed the natural interest rate. It is no surprise, then, that by mid-2008 expected inflation from breakevens started falling fast. And yet the Fed continued to fret over inflation through its September FOMC meeting of 2008. By the time it finally did cut rates and begin QE1 it was too late. The horse was already out of the barn, the ZLB had been breached.

So coming into 2008 was the economy already weak and vulnerable? Yes. Was it necessarily destined for a 'Great' recession? No. It took another shock to push it over the edge. That shock was the tightening of monetary policy in 2008. 

P.S. It appears Janet Yellen's Fed made the same mistake in its talking up of interest rates all last year.

22 comments:

  1. David The charts included are an eloquent testimony to the Fed´s grave mishandling of policy in 2008!
    https://thefaintofheart.wordpress.com/2016/02/08/the-story-behind-the-scariest-jobs-chart-ever/

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    1. Marcus, I agree a much simpler but elegant story can be told with NGDP. But, given the interest rate targeting nature of central banks, it is often easier to communicate the story via the interest rate gap.

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  2. David, I have watched you get into a hole by pushing this issue. There were issues far greater than monetary policy that led to the "deepness" of the financial crisis. And monetary policy was not that far out of whack. Even if the Fed dropped rates faster earlier, how do you think the markets would have responded? Probably the extent of the hidden shenanigans would have surfaced sooner from people wanting to understand... the message of falling rates would have been "big trouble brewing". The markets could have collapsed anyway sooner.
    Ritholtz put it into great perspective.

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    1. Ed, I guess we will have to agree to disagree on this issue. There are important lessons to be learned from this episode that I do not think have been learned and therefore it is important to revisit. For example, looking to expected path of monetary policy relative to the natural rate path as the stance of monetary policy is missed by many otherwise thoughtful people. Through this lens, the Fed repeated the mistake of 2008 in 2015 as I noted in my last post.

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    2. "For example, looking to expected path of monetary policy relative to the natural rate path as the stance of monetary policy is missed by many otherwise thoughtful people."

      OK, but what's your model for how the Fed's actions can affect these relative paths (or the relation between these paths)? Perhaps as they start to close the gap (when nominal interest rates are already low), dP/dMB approaches zero (and dNGDP/dMB as well). Aren't you just assuming they'll have no trouble like this? Perhaps a "responsible" monetary regime does have such a problem, and in order to avoid it they'd have to adopt Zimbabwe policies (a different monetary regime altogether).

      (BTW, I mention it, only because I know of such a (simple) model).

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    3. The Ritholz reply was particularly odd, especially considering that he is a popular finance blogger. He didn't seem to understand the concept of a natural rate. And his identification of easy money consisted of rate cuts, with no apparent underlying model. If that is the popular view of policy identification, then the Fed really needs to rethink communication.

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    4. A, I agree completely and that is why I think the Fed should start releasing its own estimates of the natural interest rate. It would do wonders for their communication. I did a recent post on this issue: http://macromarketmusings.blogspot.com/2016/01/a-small-step-toward-better-fed-policy.html

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    5. Tom, the Fed can affect the short-run path of the natural interest rate. In the long-run the natural rate is determined by the long-run fundamentals of the economy--population growth, productivity growth, and time preferences. But in the short-run Fed can influence economy and therefore the natural rate.

      So what is your simple model?

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    7. Here's one. I have another (more traditional and more complicated) in mind from a different author, but I'd have to get back to you about that after I contact the author.

      That 1st one generalizes what Irving Fisher brought up here. Basically the idea that an abstract price P can be defined s dD/dS, with D demand and S supply. The simplest differential equation consistent with the long term neutrality of money incorporating this price is:

      dD/dS = k*D/S

      Fisher just examined the case where the constant k=1. It also ties into what economist Gary Becker was doing in this paper in 1962.

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  3. Hi David,

    I definitely want to respond to your latest clarifications, but I have "day job" stuff. In the meantime, if you can would you either endorse / reject the following? I think your position and Sumner's are (subtly) different, so I want to stop lumping you guys together if you agree.

    KONCZAL / KRUGMAN / YELLEN: There were "real" forces setting economy up for disaster in 2008. Fed came in and helped mitigate. Maybe could've helped earlier and more, but Fed definitely helped.

    SUMNER: This is a distinction without a difference. If someone admits Fed could've prevented the crisis, that's operationally equivalent to saying Fed caused crisis.

    BECKWORTH: Yes there were "real" factors that would've caused trouble, maybe even an ordinary recession. But on top of that, the Fed inexplicably tightened (in a meaningful sense which we can precisely quantify). So far from helping, the Fed kicked the real economy when it was already in trouble.

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    1. Bob, I think you describe my view fairly well. I am not sure, though, if Scott would necessarily disagree with it. We both agree that despite there being real distortions in the economy that could not be solved by the Fed, the Fed could and did keep total demand growth stable through early 2008. I think our biggest difference is the role the Fed played in helping stoke the housing boom and therefore in making the economy more vulnerable to the Fed's mistake of 2008. But in the end we both agree the Fed blew it big time in 2008.

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    2. If the Fed is the driver controlling money debasement, then a "passive"/"active" distinction is clumsy semantics. Krugman/Konczal seem to believe that the Fed is a backseat Peewee Herman trying to move George Foreman in the driver's seat. In that case, the semantics make sense.

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  5. Another central banker catches on :

    "The Bank of Canada admits easy money can inflate debt bubbles"

    http://ftalphaville.ft.com/2016/02/08/2152624/the-bank-of-canada-admits-easy-money-can-inflate-debt-bubbles/

    Better late than never , I suppose , but I'd expect the folks who are pulling all the monetary levers to be a little quicker on the uptake.

    At least they can take some comfort in the fact that they're way ahead of the market monetarists.

    Marko

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  6. Beckworth, you mentioned Cruz in your original article. I just read this today (a quote from a Cruz speech):

    "And it’s why I think we should look at going toward rules-based monetary supply, ideally tied to gold, so you have stability."

    Why would tying rules to gold promote stability?

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    1. I don't know why I addressed you as "Beckworth." It sounds kind of obnoxious. I meant to say "David."

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    2. Tom, no worries about my name. I have been called far worse the past few weeks because that NYT times piece and the follow up Bloomberg View article.

      I think Cruz has some Robert Mundell influence lurking in the background somewhere. Mundell has been stressing the importance of a stable dollar in foreign exchange markets. Whereas Scott and me see the Fed tightening in 2008 and 2015, Mundell and Cruz would see the dollar strengthening during this time and being the source of problems. I think Cruz's proposal to peg to gold (and presumably every other country too) is his way of ending the nominal exchange rate volatility. Of course, that still leaves the real exchange rate...

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  7. The Fed needs to go to $100 billion a month of QE, and pour it on until I am using Ben Franklins to wipe my rear aperature.

    Okay, a little hyperbole, but at least I have the right idea...

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  8. @Tom Brown @7:17 PM

    Even if the d nGDP/d MB goes to zero, what is the problem if there is no inflation? If there continues to be no inflation, buy out all the central government debt, state government debt, municipal government debt in that order. Somewhere in that time, there will be inflation, right? That is when you stop.

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  9. I think Dean Baker would say that housing was at its highest share of GDP ever, that housing prices had dramatically risen from trend (with no concurrent rise of rents) and that this $800B bubble was also driving about $400B in consumption. Which just disappeared. And has never been replaced with real deficits or a trade surplus (which is an automatic drag on GDP every year that is not being replaced). Why do we need the finance story at all, other than as an exacerbating factor?

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  10. I think Dean Baker would say that housing was at its highest share of GDP ever, that housing prices had dramatically risen from trend (with no concurrent rise of rents) and that this $800B bubble was also driving about $400B in consumption. Which just disappeared. And has never been replaced with real deficits or a trade surplus (which is an automatic drag on GDP every year that is not being replaced). Why do we need the finance story at all, other than as an exacerbating factor?

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