Friday, September 3, 2010

What If the Fed Had Tightened Monetary Policy in 2003?

Dean Baker provides a nice follow-up to my last post.  He argues the Fed could and should have done something to stem the housing boom back in 2003-2004. His post reminds me of the interview Alan Greenspan did on the House of Cards documentary.  In it, Greenspan claims that if the Fed had tried to stop the housing boom it would have (1) caused a recession and (2) faced political backlash for stalling the drive for increased home ownership. I am not convinced of (1), but even if it were true surely a recession in 2003 would have been far milder than the Great Recession we are working our way through now. Household balance sheets would not be the wreck they are today and, as a result, neither would government balance sheets be so damaged (i.e. public spending stepped in to replace private spending during the recession and thus created a mess in government's balance sheet). On (2), the whole point of central bank independence is to be able to make the tough, unpopular call sometimes. Anyways, here is Dean Baker

[The NYT] notes Bernanke's statement that in 2003-2004 it was not clear that the housing market was in a bubble and that by the time it was clear, it was too late for the Fed to do anything without seriously harming the economy. Of course it was clear as early as 2002 that the housing market was in a bubble, but more importantly, Bernanke's claim that the Fed could not act until it was clear is absurd.

The Fed always acts in an uncertain environment. For example, Alan Greenspan raised interest rates in anticipation of inflation on numerous occasions. The logic of this action was that it was worth slowing the economy and raising the unemployment rate rather than risk an increase in the rate of inflation. In effect, this action assumes that the certainty of higher unemployment from raising interest rates is better than the risk of higher inflation.

Had the Fed acted to burst the bubble in 2003-2004, the risk would have been that it temporarily depressed house prices by scaring people about excessive prices and limiting the exotic mortgages that were boosting demand. By contrast, if it had acted correctly in preventing the growth of a dangerous bubble, it would have prevented the worst downturn in 70 years.

Any serious weighing of the benefits and risks of bursting the bubble in 2003-2004 would have surely come down in favor of bursting the bubble. The Fed's decision not to burst the bubble was one of the most disastrous failures of monetary policy in history.

Nice smackdown Dean!


  1. It wasn't until mid-2004 that the labor market began to recover from the previous recession. Inducing a new recession at that time would have been a blatant violation of the Fed's mandate. A mild recession coming on top another mild recession equals a severe recession. So I don't believe we would have avoided the Great Recession; we would just have moved it up in time.

  2. When Dean Baker wrote the paper he linked in mid-2002, the Case Shiller 20 City composite was at 127 (100 being Jan 2000). Today it is at 147. This is only slightly below inflation and also only slightly below the stock market's performance in that period. He can still argue that housing prices are still a bubble and thus will eventually prove his 2002 prediction correct. On the other hand, we had a huge unexpected drop in NGDP in the interim yet his projected 11-22% still hasn't happened. So how convincing is his ex ante call in supporting his argument?

  3. Andy:

    Starting with Gali (1999), there has emerged a literature that shows positive technology or productivity shocks leads to a temporary decline in labor inputs. Eventually, labor input use returns to normal and output grows strongly. A recent study along these lines was in the 2006 AER and titled "Are Technology Shocks Contractionary?"  Here is the abstract:  Yes. We construct a measure of aggregate technology change, controlling for aggregation effects, varying utilization of capital and labor, nonconstant returns, and imperfect competition. On impact, when technology improves, input use and nonresidential investment fall sharply. Output changes little. With a lag of several years, inputs and investment return to normal and output rises strongly.

    Given these findings, the slow recovery in labor markets was not very surprising over the 2002-2004 period. This period was subjected to one of the largest productivity surges in recent history so one would expect firms to use less labor for some time.  And since this labor weakness was structural in nature--it was driven by the productivity boom not weak AD--it was not something the Fed could address without creating further problems. Which is exactly what it did.

    I disagree that 2 mild recessions = 1 Great Recession. There are far more structural problems today than there were back then.  Private and Public sector balances sheets are tore up.  A second mild recession in 2003 would have stalled the very buildup of much of this debt (public balance sheet problems occurred more recently but are a consequence of the balance sheet problems in the private sector). Again, I am not convinced a second mild recession would have emerged at this time if the Fed had started tightening sooner.

  4. David
    No matter if there was or was not a House Price Bubble in 2002-04. To be consistent with yourself you cannot agree with DB that that was the cause of the "worst downturn in 70 years".
    It was the failure of MP and Bernanke´s Fed to keep AD on trend during 2008.

  5. Mr Beckworth --

    You do not address the most-promising possibility.

    Suppose that, back in 2003, the Fed had acknowledged that housing was now a more-volatile asset class. Then it could have imposed stiffer LTV and capital requirements on housing-backed loans (and derivatives). That would likely have burst the housing bubble without dragging down the overall economy. Or at least, have insulated the banks from the consequences of a bursting bubble.

    The analogy here is the 1990s' tech stock bubble. When it burst, the effects were comparatively mild, because lenders hadn't extended much credit based on those inflated equity valuations.