Friday, August 14, 2009

Martin Wolf's Counterfactual Question

Recently I had an interesting conversation with Martin Wolf of the Financial Times. We were discussing whether it was the Federal Reserve (Fed) or the saving glut from emerging markets that fueled the global liquidity glut in the early-to-mid 2000s. Martin Wolf argued it was the saving glut that was the important enabler and that the Fed's response was more or less an endogenous one. I, however, made the case that the Fed played an important role in creating the global liquidity glut given its monetary superpower status. By the end of the conversation our disagreements had narrowed, but one of the unresolved questions we ended on was whether the Fed could have acted differently given the political economy of the time. Here is Martin Wolf replying to me:
Yes, the Fed could have chosen otherwise, by a mixture of monetary and regulatory policies. I do not disagree. But to have done so would have meant a weaker recovery in domestic output. That might have been the right policy. But could it have got away with it? Who knows?
So what do you think? Could this counterfactual have happened in the 2003-2005 period? As I have noted before, productivity and aggregate demand growth were robust during this time, suggesting tightening could have occurred without harming the recovery. On the other hand, employment growth was sluggish and the political push for increased home ownership would have made tightening politically challenging. Of course, the whole point of having an independent central bank is for moments like these, when tough calls have to be made.


  1. David,
    My biggest question for the moneterists and fed supporters is this...
    What would interest rates have been if there were no FED? I think they would have been considerably higher since American savings have been pretty much zero. Now if you include "Chimerica" what would the interest rates be then? Does Asian savings make up for the lack of savings here enough to drive an interest rate to 1% where Greenspan had it. And I dont think there is ever an argument that can be made that there are enough savings to cause interest rates to be 0% like they are now.

    Neil Colston

  2. "What would interest rates have been if there were no Fed?" asks Neil.
    If John Lennon was still around, he'd have to add another line to "Imagine" wouldn't he? "Imagine no central banks, no Bernanke too. Its easy if you try....."

  3. David, have you considered just how much of that productivity growth was genuine? This was a period of tremendous FIRE expansion - the financial sector taking a larger fraction of the economy. My understanding is that there are enormous problems in measuring the productivity of financial institutions, so this productivity growth may be bogus, which would fit with the weak employment performance of this era and flat stock market.

  4. ECB:

    Good question. If FIRE did make up most of the rapid productivity growth, then it would undermine my claim that the neutral federal funds rate was increasing during the early-to-mid 2000s because productivity was increasing. I don't know enough to provide a satisfactory answer. I can think of two developments, however, that would suggest there was some real basis to the productivity boom:(1) the effect of the excessive IT spending in the late 1990s finally materialized in the 2000s and (2) the entrance of India and China to the global economy. Also, manufacturing productivity growth was on average robust during this time too. See this figure.