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.