A Question For Martin Wolf, Brad Sester, and Other Advocates of the 'Saving Glut' View

There has been a lot of talk about how current U.S. monetary policy, which has been highly accommodative for domestic reasons, is pushing up demand and thus inflationary pressures in those Asian and Gulf region countries whose currencies are pegged to the dollar. A big concern is that since these countries in the 'dollar block' make up a significant portion of the world economy, loose U.S. monetary policy is effectively creating a global monetary stimulus that may create undesired outcomes for the world economy. Nouriel Roubini describes it this way:

Easy US monetary policy, followed by monetary easing in countries that formally pegged their exchange rates to the US dollar (as in the Gulf) or that maintain undervalued currencies to achieve export-led growth (China and other informal members of the so-called Bretton Woods 2 dollar zone) has fueled a new asset bubble in commodities and overheating of their economies... [this and other] factors are akin to positive global aggregate demand shocks, which should lead to economic overheating and a rise in global inflation.

Ken Rogoff similarly notes:

[M]any countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements. As a result, whenever the Fed cuts interest rates, it puts pressure on the whole ''dollar bloc" to follow suit, lest their currencies appreciate...

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ― perhaps as much as 60 percent ― of the global economy.

But, with most economies in the Middle East and Asia in much stronger shape than the U.S. and inflation already climbing sharply..., aggressive monetary stimulus is the last thing they need right now...

Finally, Martin Wolf's says it most succinctly with the following:

To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

So the Federal Reserve is now being called to task for not being more careful with its monetary hegemon status and thus its ability to create real economic distortions in the global economy. Note, though, that the countries on the receiving end of the Fed's global monetary stimulus are the same ones that a few years ago were being blamed for creating global economic distortions via a 'saving glut'. This 'saving glut', it was argued, was so economically powerful that even the Fed's monetary policy was held hostage to it. Martin Wolf, for example, argued the following:

Prof Taylor dismisses the “savings-glut” explanation for the low US interest rates, with the observation that global savings rates are lower than three decades ago. But the world, without the US, had a rapidly rising excess of savings over investment in the early 2000s, much of it directed to the US. Given the huge capital inflow, the Fed’s monetary policy had to generate a level of demand well above potential output.

So Martin Wolf is telling us the poor Fed had no choice, it was victimized by the global saving glut and forced to lower interest rates to historically low levels. But wait, this is the same Martin Wolf we just saw above who stated that the Fed is determining monetary policy for these regions and has done it in a destabilizing fashion. Martin Wolf is not alone in this change of heart. Most observers who sang the 'saving glut' tune over the past few years are now singing--sometimes unknowingly--a global liquidity glut tune. These observers have somehow gone from a world where the Fed is a slave to the dollar block to world where the dollar block is a slave to the Fed. For these folks, then, I pose the following questions:

(1) If the Fed is a monetary hegemon and has the ability to create a global monetary stimulus with real economic effects today, is it not possible that had a similar ability to do so back in the early 2000s?

(2) If the answer is yes to (1), then is it not possible that some of global economic imbalances developed during that time were the result of the Fed's monetary policy?

Here and here are my answers to the questions.

Janet Yellen: the Fed is a Monetary Superpower

Federal Reserve Bank of San Francisco President Janet Yellen makes the case for the Fed as a monetary superpower, at least in Asia:

For all practical purposes, Hong Kong delegated the determination of its monetary policy to the Federal Reserve through its unilateral decision in 1983 to peg the Hong Kong dollar to the U.S. dollar in an arrangement known as a currency board. As the economist Robert Mundell showed, this delegation arises because it is impossible for any country to simultaneously have a fixed exchange rate, completely open capital markets, and an independent monetary policy. One of these must go. In Hong Kong, the choice was to forgo an independent monetary policy.

[...]

As in Hong Kong, Chinese officials are concerned about unwanted stimulus from excessively expansionary policies of the Fed and in other developed economies. Like Hong Kong, China pegs its currency to the U.S. dollar, but the peg is far less rigid.

[...]

Overall, we encountered concerns about U.S. monetary policy, and considerable interest in understanding the Federal Reserve's exit strategy for removing monetary stimulus. Because both the Chinese and Hong Kong economies are further along in their recovery phases than the U.S. economy, current U.S. monetary policy is likely to be excessively stimulatory for them. However, as both Hong Kong and the mainland are currently pegging to the dollar, they are both to some extent stuck with the policy the Federal Reserve has chosen to promote recovery.

I am glad to see such a high-ranking Fed official agrees with me that the Fed is a monetary superpower. Now that we have this common understanding let us explore its implications for the saving glut theory. Let us do so by referencing an older post of mine:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

I wonder what Yellen would say to the above paragraphs. More pointedly, I would love to ask her the following question: If the Fed can influence global liquidity conditions now why not in the early-to-mid 2000s? (I would also enjoy hearing Ben Benanke's answer to this question.) If so, then surely the Fed had some role in the global housing boom. Chris Crowe of the IMF and I are working on a paper that documents this superpower status of the Fed and will be sure to send Janet a copy when it is done.

Saving Glut Smackdown

The Saving Glut theory of the buildup of global economic imbalances and its application to the current economic crisis has been a popular story ever since it was introduced by Ben Bernanke. Menzie Chinn, however, has dealt a serious critique to this view that probably will be followed by others as time goes on. His view is that the Saving Glut (1) should be put to rest as an idea, (2) is mostly a mirage of the data, and (3) did not cause the current economic crisis. I agree with most of what Chinn says in this critique. I would note, however, that some of the key problems with the Saving Glut theory occur because the role of U.S. monetary policy is not properly accounted for in the analysis. Here are the problems:

(1) The Saving Glut theory has an underlying theme of inevitability. The implicit message is that the U.S. was destined to be a profligate spender because of the huge CA surpluses in Asian and oil-exporting countries. Really? Were U.S. policymakers truly constrained by the whims of foreign savers?

A key reason why this inevitability view is suspect is that it ignores a key fact: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

What is interesting is that many advocates of the saving glut view who argued the U.S. had to run a current account deficit in the early-to-mid 2000s to accommodate the current account surpluses elsewhere in the world later argued in the middle of 2008 that loose U.S. monetary policy was being exported abroad creating too much stimulus in the dollar bloc countries. In other words, these observers had somehow gone from a world where the Fed is a slave to the dollar block countries to a world where the dollar block countries are a slave to the Fed. For example, here is Martin Wolf who argued early on the inevitability of U.S. current account deficits but then had this to say in June 2008:

To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

To be fair, Martin Wolf has since come to acknowledge the U.S. monetary policy played a role. But the point is clear: if the Fed was a monetary hegemon in 2008 then it was also one in the early-to-mid 2000s. It could have tightened policy then and prevented some of the saving glut.

(2) Long-term interest rates were going down across the globe. The saving glut, however, was regionally based in Asian and oil-exporting countries and mostly went to a regionally-based saving deficit area, the United States. How, then, could a regional saving glut cause global long-term rates to decline? (This is why the saving glut explanation for the interest rate conundrum in 2005 is far from satisfactory.) An easier explanation is that Fed's low interest rates in the early-to-mid 2000s were exported across the global economy as described in (1) and transmitted to long-term rates via the expectation hypothesis of the term structure of interest rates.

(3) If the huge CA surpluses in Asian and oil-exporting countries did, in fact, lead to the lowering of long-term rates in the U.S., which in turn fueled the housing boom, why did long-term rates start rising in 2006? How is that the saving glut could fuel low rates in the early-to-mid 2000s but not thereafter? See the figure below (click on figure to enlarge):

(4) Finally, close to 40% of mortgages issued at the height of the housing boom were either subprime or Alt-A. Unlike traditional long-term, fixed-rate mortgages these other type of mortgages had financing charges tied to short-term interest rates . The Fed controls short-term interest rates. The saving glut story typically focuses on the long-term rates. As Larry White notes, the Fed's policies clearly were the big factor here.

To be clear, I do believe this crisis was more than just poor choices made by U.S. policymakers. The securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agencies failing, aggressive lending tactics, and poor choices made by lenders all contributed to the current economic crisis. However, the Fed's monetary policy choices in the early-to-mid 2000s was in my view key to making these other developments more distortionary and its role helps shed light on the problems with Saving Glut view.

A Note to the Financial Crisis Inquiry Commission

President Obama's Financial Crisis Inquiry Commission (FCIC) is under way and taking testimony from economists and other experts on what they believe were important contributors to the crisis. I was interested to see what was being said about the role U.S. monetary policy may have played in creating the crisis. Surprisingly, the only public testimony that looks closely at monetary policy's role is that of Pierre-Olivier Gourinchas.*His testimony amounts to two main points: (1) the conduct of the Fed in the early-to-mid 2000s was largely warranted given the threat of deflation and the weak employment growth then and (2) it was not so much a saving glut as it was an excess demand for safe debt instruments only available in the United States that caused excessive amounts of credit to be channeled to the U.S. economy. On both points there are alternative perspectives that paint a far less favorable view of U.S. monetary policy at the time. In case the FCIC is wondering, here are my own views on these two points:

(1) There is a good explanation for the deflationary pressures and the weak recovery in the labor market in the early-to-mid 2000s that does not justify the Fed's monetary policy at the time: strong productivity growth. Productivity growth accelerated for several years after the 2001 recession peaking in late 2003, early 2004. These rapid productivity gains were the cause of the deflationary pressure, not weak aggregate demand. In fact, by 2003 the aggregate demand growth rate was accelerating and reached about 6.5% growth in 2004. The rapid productivity gains most likely also account for much of the weak employment recovery that lasted through mid-2000s. Firms were not hiring as much labor in the recovery because less was immediately needed given the productivity surge. There is a significant empirical literature that shows productivity shocks typically lead to fewer hours worked in the short-run. Unfortunately, the Fed saw deflationary pressures and thought weak aggregate demand instead of productivity gains. It failed to make the important distinction between benign and malign deflationary pressures. [Update: For more on this distinction see here.]

Given the productivity growth-origin of both the deflationary pressures and weak employment recovery, the Fed's actions were not warranted at the time. Moreover, the Fed's response meant it was pushing real short-term interest rates into negative territory just as the rapid productivity gains were pushing up the neutral real interest rate. This interest rate disequilibrium was at the heart of the credit boom.

(2) The saving glut theory and the excess demand for safe debt instrument variation told by Gourinchas fails to acknowledge that some of the increase in excess saving from abroad is itself a result of U.S. monetary policy. As I wrote before:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

Guillermo Calvo makes a similar point. He argues that after 2002 it was fear of currency appreciation due to the Fed's easy monetary policy that drove the demand for U.S. assets, not excess foreign demand for safe debt instruments. Likewise, Maurice Obstfeld and Kenneth Rogoff argue that global savings in part had its origins with U.S. monetary policy:

We emphasize that this increase in global saving starting in 2004 plays out largely after the period Bernanke (2005) discussed in his “saving glut” speech, and arguably was triggered by factors including low policy interest rates. In our view, the dot-com crash along with its effects on investment demand, coupled with the resulting extended period of monetary ease, led to the low long-term real interest rates at the start of the 2000s. However, monetary ease itself helped set off the rise in world saving and the expanding global imbalances that emerged later in the decade. (p.22)

All of these authors and myself agree there were more factors in this crisis than just an overly accommodative U.S. monetary policy in the early-to-mid 2000s. However, monetary policy did play one of the more important roles and if the FCIC, policymakers, and the public conclude differently I fear we are doomed to repeat history.

*John B. Taylor submitted brief answers to a questionaire from the commission. His response, however, was not part of the public testimony.

It's Gone Global

Rebecca Wilder alerts us to the fact that the drop in inflation expectations is not limited to the United States:

[I]nflation expectations are falling globally. The chart [below] illustrates the 10-yr break-even expected inflation rates for the UK, Germany, Canada, Italy, and the US using their respective inflation-indexed bond markets (TIPS in the US). Notably, declining inflation expectations is not specific to the US.

Here is her chart:


What this chart says to me is that not only is the Fed allowing U.S. aggregate demand to slip, but it is also allowing global aggregate demand to falter. How so? It all goes back to the Fed's role as a monetary hegemon. As I noted earlier:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well.

The Fed's monetary hegemon status in conjunction with its loose monetary policy during the early-to-mid 2000s helped create the global liquidity glut at that time. As a consequence, there was an unsustainable boom in global aggregate demand. Now the Fed's superpower status is working in the opposite direction: it is allowing to global demand to slow down. Focus, Ben, Focus!

Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

What Role Did the Fed Play In the Housing Bubble?

I really did not want to revisit this question since  I have already covered  it here many times before.  Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played  by the Fed's low interest rate policy.  I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it  does appear  to be one of the more important ones.  Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates.  The low interest rates  at the time encouraged investors to take on riskier investments than they otherwise would have.  Some of those riskier investments end up being tied to housing.  Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Update: An good question was raised in the comments section: if the federal funds rate was below the neutral rate for so long, then why was there disinflation? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it should have been less concerned since it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation while demand growth surged. (Click on figure to enlarge.)

The Economist Magazine Forgot This Global Institution in Its Leader

The Economist has an interesting leader on the future of global institutions such as the G8, the IMF, and the UN Security Council. The article, however, makes a glaring omission when it comes to its list of important global institutions. This oversight, though, may be a good thing since there is no point in reminding the world about a highly influential global institution that is largely indifferent to the needs of the world yet highly concerned about the one country that runs it.

So what is this global institution? Let us turn to the Financial Times for the answer:

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian [and many Middle Eastern] countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

So the Fed is a monetary hegemon and its current accommodative stance, while arguably appropriate for the United States, is way too stimulative for the dollar block, those countries whose currencies are tied to the dollar. This is creating some geopolitical angst and is why the Fed should be added to the list of important global institutions.* The global reach of the Fed is something I have discussed before, but recent commentary on this issue by Brad Sester started me thinking more about the fundamental problem with this arrangement. Here is Brad Sester's take on these developments:

The battle lines here are increasingly clear: some argue that the US needs to adjust, by changing its monetary policy to help out countries pegging to the dollar, others argue the rest of the world needs to adjust by letting their currencies appreciate. The US is calling for other countries to have more monetary policy autonomy, and others are calling for the US to, in effect, have a bit less.

...Should the dollar be managed as the world’s currency not the United States’ currency? Does the US derive such large benefits from the dollar’s global role that it should adjust its monetary policy — at a potential cost to the US economy — in order to make it easier for other countries to peg to the dollar?

I would say no. I have long criticized a global monetary and financial system where dollar-reserve growth in the emerging world sustains large US deficits. Over time, the US — and the world — would be better off if Asia and the oil-exporting economies let their currencies float against both the dollar and the euro rather than pegging to the dollar (or managing their currencies against the dollar).

Brad's point is that this arrangement is the one of the main reasons for the global economic imbalances--the large, ongoing U.S. current account deficits and the financing for them from Asia and the Gulf region--and is therefore unsustainable. I agree with Brad's conclusions, but have started thinking about this problem from a different perspective: the dollar bloc an optimum currency area (OCA). Consider the standard criteria of an OCA: similar business cycles, mobile labor, flexible prices/wages, fiscal transfers, diversified economy. The main regions of the dollar block--U.S., Asia, and the Gulf region--fail to meet the OCA criteria on most counts. For example, the U.S. economy is slowing down while the rest of the dollar block is overheating. Or, when was the last time you saw a mass exodus of former Rustbelt workers moving to China or heard of a fiscal transfer from the Gulf region to the Rustbelt? By my reckoning, then, the OCA criteria also indicates the dollar block countries should abandon their pegs and take on more monetary policy autonomy.

With that said, I am fearful of what would happen to the U.S. economy if the dollar block countries abandoned their dollar pegs anytime soon. The Fed's job would certainly be made more challenging and potentially there could be a run on the dollar. In the near term, then, it may be more sensible for the Fed to acknowledge its role as a monetary hegemon and take the lead in fighting global inflation. (Actually, I would have the Fed stabilize global nominal spending, but I digress). This may have some domestic economic consequences, but it would (1) help reign in global inflation and (2) give more time to dollar block to hammer out a coordinated plan of separation.

*According to Ken Rogoff, these countries make up about 60% of the global economy so the Fed's influence is significant.

Why The Low Interest Rates Mattered: Part II

This is the second of two posts detailing why the Fed's low interest rate policies in the early-to-mid 2000s was one of the more important contributors to the credit and housing boom.  In the first post I discussed how the low federal funds rate acted as a catalyst in bringing together the other contributors--financial innovation, weak governance, misaligned incentives, and globalization--to create the perfect economic storm.  Here I want to (1) flesh out why the low federal funds rate mattered from a neutral interest rate perspective and (2) discuss how the Fed's low interest rate policy created a global liquidity glut. (The material in this post is mostly excerpted from a previous one of mine.)

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate (click on figure to enlarge):

In short, during the early-to-mid 2000s the real federal funds rate was being pushed to an unusually low level just as the neutral real federal funds rate was rising because of the productivity boom.   Thus, monetary policy was highly stimulative.

A natural follow-up question is that if the federal funds rate was below the neutral rate for so long, then why was there strong disinflation during this time? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation.  Demand growth, meanwhile, is solidly recovering (click on figure to enlarge):

(2) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

Given these points and those noted in the previous post, I am convinced that the Fed probably  was one of the more important contributors to the credit and housing boom. If nothing else, it was the one institution that could have slowed down the housing boom through better oversight of lending practices and less monetary stimulus.   

Obstfeld and Rogoff's New Paper

Mark Thoma directs us to a new paper by Maurice Obstfeld and Kenneth Rogoff titled Global Imbalances and the Financial Crisis: Products of Common Causes. In this paper the authors acknowledge that highly accommodative U.S. monetary policy in the early-to-mid 2000s in conjunction with other developments played an important role in the build up of global economic imbalances. In their discussion of U.S monetary policy, interest rates, and global liquidity conditions they miss, however, some important points on the issues of (1) productivity growth and (2) the monetary superpower status of the Federal Reserve. Let me take each point in turn.

The first point comes up when Obstfeld and Rogoff criticize the saving glut explanation for the decline in long-term interest rates that began in the early 2000s. They rightly expose the holes in the saving glut story but then turn to a less-than-convincing explanation for the decline in the long-term interest rates. Here are the key excerpts:

[T]he data do not support a claim that the proximate cause of the fall in global real interest rates starting in 2000 was a contemporaneous increase in desired global saving (an outward shift of the world saving schedule)... according to IMF data, global saving (like global investment, of course), fell between 2000 and 2002 by about 1.8 percent of world GDP... [A]n end to the sharp productivity boom of the 1990s, rather than the global saving glut of the 2000s, is a much more likely explanation of the general level of low [long-term] real interest rates.

So their story is that the productivity surge of the 1990s ended and pulled down long-term interest rates. This is a plausible story since productivity growth is a key determinant of interest rates, but the data does not fit the story. Below is a figure showing the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed (Click on figure to enlarge):


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. Rather than pushing interest rates down this indicates they should have gone up. That still leaves the question of why long-term interest rates declined during this time. My tentative answer is that it was some combination of (1) a drop in the term premium that itself was the result of a false sense of security created by the Great Moderation and (2) and expectations of future short-term interest rates being low because of accommodative monetary policy.

The productivity point, however, does not end there. It becomes important in understanding why the Fed continued to keep interest rates so low for so long. As the authors note in the paper:

In early 2003 concern over economic uncertainties related to the Iraq war played a dominant role in the FOMC’s thinking, whereas in August, the FOMC stated for the first time that “the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” Deflation was viewed as a real threat, especially in view of Japan’s concurrent struggle with actual deflation, and the Fed intended to fight it by promising to maintain interest rates at low levels over a long period. The Fed did not increase its target rate until nearly a year later.

In other words, the fear of deflation is what motivated Fed officials to keep interest rate low for so long. As I have noted many times before, though, the Fed's fear of deflation at this time was misplaced. Deflationary pressures emerged not because the economy was weak, but because TFP growth was surging as shown above. The Fed saw deflationary pressures and thought weak aggregate demand when in it fact it meant surging aggregate supply. Making this distinction is important if monetary policy wishes to fulfill its mandate of maintaining full employment. Not making this distinction in 2003-2004 meant an economy already buffeted by positive aggregate supply shocks (i.e. productivity surge) got simultaneously juiced-up with positive aggregate demand shocks (i.e. historically low interest rate policy). This was a sure recipe for economic imbalances to emerge somewhere.

The second point with the Obsteld and Rogoff's paper is that it fails to appreciate how important is the Fed's monetary superpower status. As I have explained before

the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Obstfeld and Rogoff actually hint at this possibility briefly when they say the following:

the dollar’s vehicle-currency role in the world economy makes it plausible that U.S. monetary ease had an effect on global credit conditions more than proportionate to the U.S. economy’s size.

But then they go on to say

While we do not disagree entirely with Taylor [who believes the Fed was too accommodative in the early 2000s], we argue below that it was the interaction among the Fed’s monetary stance, global real interest rates, credit market distortions, and financial innovation that created the toxic mix of conditions making the U.S. the epicenter of the global financial crisis.

I agree that there were many factors at work, but if you accept that the Fed is a monetary super power and therefore helped generate the global liquidity glut then it could have also tightened global liquidity conditions and helped pushed the global interest rates toward a more neutral stance. And without the global liquidity glut it seems that many of the other credit market distortions that arose at the time would have been far less pronounced.

Greenspan's Failed Attempt to Exonerate the Fed

Alan Greenspan is again defending U.S. monetary policy under his watch. Writing in the Wall Street Journal last week he acknowledges interest rates were too low in the past decade, but not the short-term interest rate targeted by the Federal Reserve (Fed). Rather, it was those stubborn long-term mortgage rates that failed to go up when the Fed started its tightening cycle in 2004. So do not blame the Fed, blame those folks overseas whose excess savings were funneled into the United States and, in turn, pushed down long-term interest rates. These are the real culprits according to Greenspan.

Greenspan's defense is wrong on several counts.

First, as noted by observers such as Barry Ritholtz and Larry White much of the problematic mortgage lending took place under adjustable rate mortgages, interest-only mortgages, and other non-traditional mortgages whose interest rates were tied to short-term interest rates. Thus, the Fed's super low interest rate policy in the early-to-mid-2000s was highly consequential to these types of loans.

Second, Greenspan's invoking of the interest rate "conundrum"--the Fed pushing up short term rates in the mid-2000s but long-term rates not following--and explaining it away by the foreign saving glut makes it appear that the Fed was helpless at that time. As Greg Ip shows this was not the case. The Fed could have tightened monetary policy or tightened the lending standards in the mortgage industry. While Greg is technically correct, I will go one further and say the saving glut story is at best a partial explanation for the conundrum. Another more compelling story is that there was no conundrum, but rather the bond market was expecting a recession in the near future and pricing it into long-term interest rates. In short, the conundrum was simply the case of a yield curve inverting and pointing to a recession. Moreover, this explanation makes sense in light of the fact that yield curves across the globe were flattening or inverting and thus indicating a global recession was in store. (See here and here for more).

Third, Greenspan overlooks the fact that Fed is a monetary superpower whose loose monetary policy got exported to the rest of the world in the early-to-mid 2000s. As I wrote earlier:

One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

This global liquidity glut served to facilitate a global credit expansion and as a result, a global housing boom. Yes, there was also a saving glut coming out of Asia and oil-exporting countries but it was more important to the story beginning about 2005 after the Fed's tightening cycle had begun to be take hold.

Finally, the original motivation for Greenspan's easing in the early-to-mid 2000s was a case of misreading the deflationary pressures. As documented in this post, nominal spending was not collapsing at the time. Also, the lack of robust employment gains coming out of the 2001 recession were not alarming given the robust productivity growth and the (policy-induced) low interest rates that encourage inordinate substitution of capital for labor.

To be clear, there were other developments such as the the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. that contributed to the current economic crisis. The Fed's role in this crisis, though, is unmistakable and clear. Consequently, no matter how many editorials Greenspan writes he will never be able to exonerate the Fed from the responsibility it bears for this crisis.

A Misguided Greenspan Defender

Alan Greenspan has been busy lately defending his legacy. He is responding to the ground swell of opinion that views him as a key contributor to the U.S. housing boom-bust cycle. Fortunately for him, he has one prominent observer coming to his defense: Martin Wolf of the Financial Times. Here is what Martin has to say:

When a wave of destruction hits, everybody looks for somebody to blame. Alan Greenspan, former chairman of the US Federal Reserve, once lauded as the “maestro”, has, to his discomfort, become the scapegoat... much of the criticism is highly unfair.

[...]

US monetary policy cannot be responsible for all these bubbles. This might not be the case if these other countries had followed US policy slavishly...

Really? What do we know about the ECB? Did it follow the Fed's lead in cutting rates? Here is a graph from the IMF's latest WEO report that sheds some light on this question:


It sure looks to me like the ECB followed the Fed's lead in cutting short-term interest rates. If we look at real short-term interest rates the picture is even more stark:

Both the Fed and the ECB pushed short-term real interest rates into negative territory for a sustained period. Negative real interest rates in a growing economy are a sure way to light an asset bubble fire. Now take a look at the following graph. It indicates these downward interest rate moves were policy-driven:
This figure shows a large spike in the policy-determined monetary base relative to the G3's GDP. In sum, these figures indicate loose monetary policy in the U.S. and the ECB coincided with the global housing bubble.

An important question these figures do not answer is why would the ECB (and other monetary authorities) follow the Fed's lead in loosening monetary policy? The answer is that the Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. The Fed's loosening, therefore, of monetary policy in the early-to-mid 2000s triggered a global liquidity glut that set the stage for the subsequent housing boom-bust cycle. This is not to say the 'saving glut' and financial innovation had no role, but rather that loose monetary policy was a key factor behind the boom.

William Buiter writing at Financial Times does a nice view articulating this view in his article titled "The Greenspan Fed: A Tragedy of Errors":

Mr Greenspan is correct that a major global decline in risk-free real interest rates was an important factor in the housing booms that occurred in a couple of dozen countries between, say, 2002 and the end of 2006[.]

But the fact that on top of these very low risk-free long-term real rates, credit spreads became extraordinary low, had something to do with the liquidity glut created by the Fed, the Bank of Japan and, to a slightly lesser extent, the ECB. The Fed kept the Federal Funds rate target too low for too long after 2003. Because of the unique role played by the US dollar in the global financial system, the US dollar liquidity shower not only soaked the US economy, but also many others. First those who kept a formal or informal peg vis-a-vis the US dollar. Then those whose monetary authorities, without pursuing a dollar peg, kept a wary eye on the exchange rate with dollar, and ultimately most central banks in the globally integrated financial system.

Well said Dr. Buiter.

They Did It, They Did, They Did It!

Lately, that seems to be the message coming from current and past Fed officials regarding the housing and credit boom in the early-to-mid 2000s.  First Ben Bernanke, then Vincent Reinhart, and now Janet Yellen have come out saying it was excess savings by foreigners and failings in the U.S. private sector that was the root cause of the boom.  No blame is assigned to the Fed.  They ask how could the Fed have created a liquidity glut that drove down world interest rates and sparked off a global housing boom?

The answer is easy: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). As I showed in a recent post, there is strong evidence that a good portion of the foreign reserve buildup in the global economy during the 2000s can be tied to U.S. monetary policy.

What is amazing is that on one hand these Fed officials will acknowledge the Fed's global monetary power and then completely ignore the implications of this for early-to-mid 2000s.  I wish they wrestle with the four questions I presented to Ben Bernanke after his recent speech.   In case any of these Fed officials are interested, I am about to wrap up a coauthored paper that more fully develops the implications of the Fed's monetary superpower status during the housing boom. I would be glad to share it with them.

Update:  Here is a paper from the ECB that empirically estimates how important the global saving glut was versus monetary policy.  This is the abstract:

 Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.

The First Crack in the Fed's Armor

The WSJ is reporting that former NY Fed President and now U.S. Treasury Secretary Timothy Geithner admitted that the loose monetary policy of the Fed and other central bankers in the early-to-mid 2000s contributed to the economic imbalances that led to this current economic crisis:

I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful...It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.

For all the grief the Treasury Secretary is receiving, he should be given credit for this admission of policy failure. I would note, though, that monetary policy was highly expansionary across the globe primarily because it was expansionary in the United States. As I have noted earlier:

The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

I am hoping the Secretary's admission will open the door for a mea culpa from those Fed officials who actually oversaw U.S. monetary policy at this time. If we are to learn from this experience we need to come clean on all the contributors to this economic crisis.

Empirical Evidence on the Fed as a Monetary Hegemon

I recently made the following claim:

[The] Federal Reserve is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are pegged to dollar. Thus, it's monetary policy is exported across the globe. This means that the ECB, even though the Euro officially floats, has to be mindful of U.S. monetary policy lest its currency becomes too expensive relative to the dollar and all the other currencies pegged to the dollar.

I suspect the most contentious part of this claim is the part where I said the ECB has to be mindful of the Fed's actions. I made a case for this view based on a figure that showed the path of the policy rates for the Fed and the ECB. Fortunately, I can now point you to more rigorous empirical work by John Taylor that supports my position:

...Many central bankers, even those with flexible exchange rate policies, watch the U.S. federal funds rate carefully when making policy decisions.

To illustrate this issue consider the relationship between Eurozone interest rates and U.S. interest rates during the past few years. Consider in particular the deviation of the overnight interest rate target for the European Central Bank from a simple guideline for that interest rate—the Taylor rule...

Now if one examines the relationship between this deviation and the actual federal funds rate in the United States during the period from 2000 through 2006, one finds a close empirical correlation between the two. An estimated linear relationship with the deviation on the left hand side has a coefficient on the federal funds rate of 0.21, which means that each percentage point reduction in the federal funds rate was associated with a 1/5 percentage point reduction in the ECB interest rate below what would otherwise be desirable on European price stability and output stability grounds... The relationship is highly significant statistically... For part of this period the ECB policy rate was below this guideline and according to these estimates a significant part of the deviation is “explained” by the U.S. federal funds rate being lower than normal.

You can read the rest here.

Bernanke Goes for the KO and Misses

Ben Bernanke came out swinging today throwing some hard punches at those critics who say the Fed's monetary policy was too accommodative in the early-to-mid 2000s. He does so by throwing the following four-punch combination of arguments: (1) economic conditions justified the low-interest rate policy at the time; (2) a forward looking Taylor Rule actually shows the stance of monetary policy was appropriate then; (3) there is little empirical evidence linking monetary policy and the housing boom; and (4) cross country evidence indicates the global saving glut, not monetary policy was more important to the housing boom. Though Bernanke rejects the view that interest rates were too low for too long in this speech, he does acknowledge the Fed could have been more vigilant in regulatory oversight of lending standards. By far this is one of the better defenses of the Fed's low-interest rate policy of the early-to-mid 2000s that I have seen. Arnold Kling seems convinced by this rebuttal while Mark Thoma appears more agnostic about it. While Bernanke's case seems reasonable for the 2001-2002 period, I find his arguments far from convincing on all four points for the period 2003-2005 and here is why:

(1) By 2003 economic conditions did not justify the low-interest rate policy. Aggregate demand (AD) growth was robust, productivity growth was accelerating, and the ouput gap was near zero by mid 2003. The following figure shows the robust AD growth rate--measured by final sales of domestic product--and how the federal funds rate markedly diverged from it in 2003 and 2004 (marked off by the lines):


Note this rapid growth in AD indicates there was no threat of a deflationary collapse. Then what about the low inflation? That came from the robust productivity gains, not weak AD growth. The following figures shows the year-on-year growth rate of quarterly total factor productivity (TFP) for the United States. The data comes John Fernald of the San Francisco Fed:


This figure shows the TFP growth rate did slow town temporarily in 2001 but resumed and even picked up its torrent pace for several years. It is also worth pointing out that this surge in productivity growth was both widely known and expected to persist. Productivity gains, then, were the reason for the lower actual and expected inflation. [It is also worth noting that productivity growth typically means a higher real interest rate which serves to offset the downward pull of the expected inflation component on the nominal interest rate. In other words, deflationary pressures associated with rapid productivity gains do not necessarily lead to the zero lower bond problem for the policy interest rate (Bordo and Filardo, 2004).] The big policy mistake here, then, is that the Fed saw deflationary pressures and thought weak aggregate demand when, in fact, the deflationary pressures were being driven by positive aggregate supply shocks. The output gap as measured by Laubach and Williams also shows a near zero value in 2003 that later becomes a large positive value. As Bernanke notes, though, there was a jobless recovery up through the middle of 2003. This can, however, be traced in part to the rapid productivity gains. The rapid productivity gains created structural unemployment that took time to sort out, something low interest rates would not fix. In short, it is hard to argue economic conditions justified the low interest rate by 2003.

(2) A forward looking Taylor Rule does not close the case that the stance of monetary policy during 2003-2005 was appropriate. Bernanke cleverly constructs an "improved" Taylor rule that has a forward looking inflation component to it and finds monetary policy was actually appropriate during this time. Now a forward looking rule does make sense but invoking it now appears as an exercise in ex-post data mining to justify past policy choices. Regardless of this Taylor Rule's merits, there is still reason to believe Fed policy was too accommodative during this time. As mentioned above, productivity growth accelerated and it is a key determinant of the natural or equilibrium real interest rate. Typically, higher productivity growth means a higher equilibrium real interest rate. The Fed however, was pushing real short-term interest rates down--a sure recipe for some economic imbalance to develop. Below is a figure that highlights this development. It shows the difference between the year-on-year growth rate of labor productivity and the ex-post real federal funds rate with a black line. A large positive gap--i.e. productivity growth greatly exceeds the real interest rate--emerges during the 2003-2005 period. This gap is also seen using the difference between an estimated natural real interest rate (from Fed economists John C. Williams and Thomas Laubach) and an estimated ex-ante real federal funds rate (constructed using the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters):



This figure indicates the real federal funds rate was far below the neutral interest rate level during this time. These ECB economists agree. Further evidence that Fed policy was not neutral can be found in the work of Tobias Adrian and Hyun Song Shin who show that via the "risk-taking" channel the Fed's low interest rate help caused the balance sheets of financial institutions to explode.

(3) There is evidence (not mentioned by Bernanke) that points to a link between the Fed's low interest rate policy and the housing boom. For starters, here is a figure from a paper that I am working on with George Selgin. It shows the gap discussed above between TFP growth and the real federal funds rate and the growth rate of housing starts 3 quarters later:

Also, below is a figure plotting he federal funds rate against the effective interest rates on adjustable rate mortgages, an important mortgage during the housing boom:


They track each other very closely. Bernanke, however, argues it was not so much the interest rates as it was the types of mortgages available that fueled the housing boom. My reply to this response is why then were these creative mortgages made so readily available in the first place? Could it be that investors were more willing to finance such exotic mortgages in part because of the "search for yield" created by the Fed's low interest policy?

(4) While there is some truth to saving glut view, the Fed itself is a monetary superpower and capable of influencing global monetary conditions and to some extent the global saving glut itself. As I have said before on this issue:

The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

With that background I turn to Guillermo Calvo who argues the build up of foreign exchange by emerging markets for self insurance purposes--a key piece to the saving glut story--only makes sense through 2002. After that it is loose U.S. monetary policy (in conjunction with lax financial regulation) that fueled the global liquidity glut and other economic imbalances that lead to the current crisis:

A starting point is that the 1997/8 Asian/Russian crises showed emerging economies the advantage of holding a large stock of international reserves to protect their domestic financial system without IMF cooperation. This self-insurance motive is supported by recent empirical research, though starting in 2002 emerging economies’ reserve accumulation appears to be triggered by other factors.² I suspect that a prominent factor was fear of currency appreciation due to: (a) the Fed’s easy-money policy following the dot-com crisis, and (b) the sense that the self-insurance motive had run its course, which could result in a major dollar devaluation vis-à-vis emerging economies’ currencies.

Calvo's cutoff date of 2002 makes a lot sense. By 2003 U.S. domestic demand was soaring and absorbing more output than was being produced in the United States. This excess domestic demand was fueled by U.S. monetary (and fiscal) policy and was more the cause rather than the consequence of the funding coming from Asia.

Conclusion: Bernanke fails to make a KO of Fed critics with this speech.