Friday, January 31, 2014

The Two Big Failures of the Bernanke Fed

The Bernanke era at the Fed came to an end today and many are already opining on what it means. Many smart things have been said about the Bernanke Fed, but most accounts have overlooked two of its biggest failures. No assessment of the Bernanke Fed is complete without recognizing them. So what were these two failures?

First, the Bernanke Fed never tried Abenomics. That is, for all the Fed has done over the past five years it never tried to do the kind of monetary regime change now being done by the Bank of Japan. A year ago, Japanese monetary authorities shook things up by credibly committing to permanently raising the nominal size of the Japanese economy. The evidence so far shows this program to be a smashing success. From the start, the Bernanke Fed took the opposite approach. It credibly committed to a temporary expansion of its balance sheet. The U.S. monetary injections, therefore, were never intended to be permanent and this makes all difference in the efficacy of monetary policy.

So for all the praise the Bernanke Fed gets for preventing the second Great Depression, it should be equally noted that it allowed the long slump. By failing to do Abenomics for the U.S. economy, the Bernanke Fed effectively kept monetary policy tight for the past five years. There is no other way to say it.

Okay, maybe there is another way to say it. The Bernanke Fed failed to meaningfully address the endogenous fall in the money supply and the decrease in money velocity. The Bernanke Fed could have done an American version of Abenomics, like nominal GDP level targeting, that would have arrested these developments. Instead, it did not and passively allowed total dollar spending to remain depressed. This failure to act is no different than an explicit tightening of monetary policy in terms of damage done to the economy. The only difference is that the public is more aware of the explicit form.

In my view, this is the biggest failure of the Bernanke Fed. It had  many opportunities to do it and much encouragement (e.g. Christina Romer's call for Ben Bernanke to have a a Volker Moment). But it was not the only serious failure. There was another big one that preceded it. 

This failure is that the Bernanke Fed in 2008 arguably turned what would have been an otherwise mild recession into the Great Recession. Over at Bloomberg opinions, Ramesh Ponnuru recently discussed this failure:
There's another view of the Fed's role in the crisis, though, that has been voiced by economists such as Scott Sumner of Bentley University, David Beckworth of Western Kentucky University and Robert Hetzel of the Richmond Fed. They dissent from the prevailing view that the Fed has been extremely loose since the crisis hit. Instead, they argue that the Fed has actually been extremely tight, and that when its performance during the crisis is measured against the proper yardstick, the central bank emerges as the chief villain of the story.

In the second half of 2008, housing prices, many commodity prices, inflation expectations and stocks all suggested deflation was coming. Fed officials, though, kept talking about backward-looking measures of inflation that made it look high. Their hawkish pronouncements effectively tightened monetary policy by shaping market expectations about its future direction. In August 2008, the Fed minutes explicitly said to expect tighter money. Even after Lehman Brothers Holdings Inc. collapsed the following month, the Fed refused to cut rates and fretted about inflation (which didn't arrive). A few weeks later, the Fed decided to pay banks interest on excess reserves, a contractionary move. Only then did it cut interest rates.
Looking back, the Fed's response from about mid-to-late 2008 was amazingly bad. It had done a decent job over the previous two years as the housing sector was undergoing its own recession, but for some reason lost focus in mid-2008. I believe it got overly worried about headline inflation. By failing to act more aggressively during this time, the Fed allowed monetary conditions to passively tighten. Here is how I previously described this period :

[t]he Fed passively tightened monetary policy starting around mid-2008.  This can be seen in the figure below:

The figure shows that despite the fall in the growth rate of personal income from construction and real estate services that began in early 2006, personal income in the rest of the economy continued to grow at about 5% a year up through mid-2008.  The Fed was able to stabilize nominal incomes overall for almost two years while structural changes were taken place in those sectors closely tied to the housing boom.  This is a remarkable accomplishment and is especially clear when comparing construction employment with all other employment:

But around mid-2008 the Fed began failing to sufficiently respond to the decline in expected aggregate demand growth.  Thus, it began passively tightening around that time as can be seen in the two figures below.  The first figure shows the spread between the nominal and real yield on 5-year treasuries.  It fell about 170 basis points during the period leading up to the collapse of Lehman in September.  This decline in inflation expectations implies a decline in expected aggregate spending and thus a passive tightening of monetary policy. (Even if the spread was reflecting a heightened liquidity premium during this time the implication is the same. A heightened liquidity premium indicates increased demand for liquidity that, in turn, also implies less spending.)

The decline in expected aggregated demand began affecting current spending decisions as seen below.  Nominal GDP began falling in June 2008.

The Fed's failure to stabilize and restore aggregate spending meant it was passively tightening.  This failure to act was epitomized by the Fed's decision in September, 2008 to not lower the federal funds rate despite the collapsing economy.  This passive tightening is what turned a mild recession into the Great Recession.
Though this Bernanke failure was big, I do view it as less heinous than the failure to do an Abenomics-like program. The 2008 failure happened in real time and would have been difficult for anyone to have nimbly responded these developments. Still, my sense is that more could have done  in both cases and this is why I consider them to be the big failures of the Bernanke Fed.


  1. "The U.S. monetary injections, therefore, were never intended to be permanent and this makes all difference in the efficacy of monetary policy. "
    I'm still a bit confused by this. If the fed is committing to a permanently higher CB balance sheet then how could it also commit to a stable growth in NGDP ? What happens if the demand for money goes down and a smaller balance sheet is needed to keep NGDP on track. If the aim is stable NGDP growth then a CB would appear to be inconsistent to commit to a higher/lower CB balance sheet.

  2. It was not until Bankrupt you Bernanke's appointment, that the rate-of-change (roc) in monetary flows (our means-of-payment money times its transactions rate-of-turnover), i.e., the proxy for inflation contracted (was a negative figure) for 29 consecutive months. However, even during this period of "tight" money, the roc in the proxy for real-output did not fall below zero (based on gDp calculation periods), until the 4th qtr of 2008.

    Of course, you can't decipher this ex post as the calculations for the roc in MVt are always ex ante (not "real time"). I.e., the lag effects for money flows (proxies for real-growth & inflation indices), have been mathematical constants for the last 100 years. The 4th qtr of 2008 was predictable & was predicted as of December 2007.

    Remember that St. Louis Fed's technical staff surmised: “Although the evidence is mixed, the MSI (monetary services index), overall suggest that monetary policy WAS ACCOMMODATIVE before the financial crisis when judged in terms of liquidity. —Richard G. Anderson & Barry Jones.

  3. The egregious error was the introduction of the payment of interest on excess reserve balances during the 4th qtr of 2008. By creating an interest rate differential in favor of the commercial banking system, the CBs (principally primary dealers), were able to outbid the non-banks & non-bank public for loan-funds (in this case "specials" or gov'ts).

    This new "tool" had the effect of emasculating the Fed's "open market power". Whereas between 1942 & 2008 the commercial bank managers minimized their non-earning assets (excess reserves), so as to always remain fully "lent up", with a remuneration rate that exceeded all wholesale short-term money market funding, they received higher returns than the short-term debt obligations (t-bills) they would have previously purchased from the non-bank public. I.e., QE was concentrated with the commercial banks (as the loans = deposits reconciliation shows), & not the financial intermediaires (non-banks).

    So "pump priming" couldn't work as transactions between the Reserve bank & the commercial banks only serve to create new excess reserves, whereas, transactions between the commercial banks & the financial intermediaries creates both new excess reserves and expands the money stock. QE was doomed from the getgo.

    The Fed's 300 Ph.Ds in economics don't know the difference between money & liquid assets, between money creating depository institutions & financial intermediaries.

  4. Excellent blogging--and is the Fed preparing for Big Mistake #3? I think so...premature withdrawal from QE...and a squeamish aversion towards "large" balance sheet...but maybe the Fed should have a large and slowing growing balance sheet...

    1. The Fed has no choice here. The Fed is not going to take all the losses in one shot just to keep the stocks up. The Fed is going to let rates rise and spread the losses it has accumulated over time. Actually, the Fed has been pretty lucky that the bond market hasn't started selling in droves, collapsing the market.

      Every single action has an equal and opposite reaction. Out of everyone in the world - you'd think teachers would know this stuff. And you'd also think teachers would preach liberty instead of manipulation.

      It's what socialism and communism does. After all, we have to first beat you up for your own good. Trust us.... Amazing...

  5. Roc's in MVt = roc's in nominal-gDp (proxy for all transactions in Irving Fisher's "equaltion of exchange" MVt=PT). The roc in the proxy for real-output peaked early & at subpar levels this year. That's why stocks are falling. If the Fed's research staff targeted nominal-gDp levels, it would be much more aggressive at the present juncture.

    I.e., the Fed's "open market power" potential is awesome. Even with the pervasive arrogance & ignorance that characterizes the Keynesian economists at the Fed, they have the tools to make "abrupt policy adjustments". The "trading desk" did so on "Black Monday". Black Monday represented the sharpest contraction (as most of the Fed's errors), in the roc in MVt since the Great Depression. But immediate open market operations of the buying type reversed & corrected the trend in money flows. Same story with the "flash crash" of May 6th 2010. You could see this developing 6 months in advance.

    Bankrupt you Bernanke was not only responsible for the Great-Recession, he prolonged its recovery.

  6. POSTED: Dec 13 2007 06:55 PM |
    10/1/2007,,,,,,,-0.47,,,,,,, -0.22 * temporary bottom
    11/1/2007,,,,,,, 0.14,,,,,,, -0.18
    12/1/2007,,,,,,, 0.44,,,,,,,-0.23
    1/1/2008,,,,,,, 0.59,,,,,,, 0.06
    2/1/2008,,,,,,, 0.45,,,,,,, 0.10
    3/1/2008,,,,,,, 0.06,,,,,,, 0.04
    4/1/2008,,,,,,, 0.04,,,,,,, 0.02
    5/1/2008,,,,,,, 0.09,,,,,,, 0.04
    6/1/2008,,,,,,, 0.20,,,,,,, 0.05
    7/1/2008,,,,,,, 0.32,,,,,,, 0.10
    8/1/2008,,,,,,, 0.15,,,,,,, 0.05
    9/1/2008,,,,,,, 0.00,,,,,,, 0.13
    10/1/2008,,,,,,, -0.20,,,,,,, 0.10 * possible recession
    11/1/2008,,,,,,, -0.10,,,,,,, 0.00 * possible recession
    12/1/2008,,,,,,, 0.10,,,,,,, -0.06 * possible recession
    Exactly as predicted:

    Even as the Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.

  7. So...should the Fed commit or prepare some forward guidance that the increase in the size of its balance sheet is permanent or very long term?

  8. GDP figures are reported too late to target. And the futures market would target a figure averaged over a 3 month period. Economic ocillations sometimes expand & contract very quickly (lots of times dramatically within a single month). And economic ocillations may overlap 2 of the BEA's reporting periods. The 3.2% real-gDp pace for the 4th qtr slowed this Jan-Feb. Do policy makers really want to wait until trading positions are settled before acting?

  9. "So for all the praise the Bernanke Fed gets for preventing the second Great Depression..."

    I actually believe Bernanke did a decent job, but I don't think he has earned this credit. US labor participation took a bit dive in 2008, and it has stayed low since---Brad Delong estimates it's about 4.5% below long-term trend, as of early 2012.

    Similarly, nominal GDP declined to about $0.8tn. below long-term trend in '08-'09, and since then the trend and actual lines have been very nearly parallel, with little closing of the gap (it may have tightened to $0.7tn. by now).

    A sharp recession that started in 2008 has led to a long-term slump in economic activity and surplus US unemployment around the figure of 6 million non-working adults, and both have persisted for more than five years now. I don't know what you call that if not a second Great Depression.

  10. Bernanke did a terrible job and any other chairman/woman would do an equally or worst job. Bernanke's (and congress's) legacy:

    - Bailed out the banks and created a moral hazard (the banks will do it again)
    - Has created another bubble in equities and bonds
    - Has distorted price discovery in various markets
    - Has been subsidizing government spending at the expense of pension funds

    FDR's un-peg of the gold standard packed a punch? Are you referring to a punch that led to a world war? The US would still be in a depression if not for WWII. The real punch came in 1913 when the US installed the Central Bank and began playing around with fractional reserve lending - which by the way, is what caused the great depression. The other punch came in 1971, when the US went completely off the gold standard and has made complete slaves of the population by replacing incomes with debt. Your arguments would be valid if people were doing better after ditching gold - the opposite is true, however.

    Anyway, the Fed can only issue credit - and cannot cause inflation by itself. The congress can do that. Even if the Fed could cause higher inflation - it would do no such thing which would destroy the banks. Abenomics will fail - what will your excuse be when it does - that it wasn't "large" enough?

    1. Vanessa, the claims you make about Bernanke's legacy are highly contestable. For example, you assert Bernanke has subsidized government spending. Beckworth and others have argued that interest rates were low not because of the Fed, but because of the weak economy. (See Beckworth's links on the right.) Your history of the interwar gold standard also seems to lack important nuance. Most economic historians, for example, attribute the interwar gold standard contributed to Hitler's rise. Also, the sooner countries left the gold standard in the 1930s, the sooner they had a recovery. Gold is not some panacea. It was accident of history that worked well for a time, but history left it behind.