Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake

Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure below (click on figure to enlarge):


Here we see productivity growth soaring just as the real federal funds rate is being pushed into negative territory. Normally, a rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):


The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here.

The final data issue is the weak employment growth coming out of the 2001 recession. Given the above discussion, the best interpretation of this development is there was less demand for labor in the recovery given the productivity gains. In fact, this was common explanation given at the time. One could also argue that the Fed's low interest rate policy may have pushed some firms to inordinately substitute out of labor to capital.

Here is the bottom line: there is enough evidence for Brad DeLong to conclude that Federal Reserve's low interest rate policy was a mistake.

Update: Brad DeLong responds to this and other posts.

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.

What Happened to Private Sector Job Growth?

That is the question I had after reading Michael Mandel's article on the declining private sector job growth over the past decade. Here is the money graph (click on figure to enlarge):


Mandel goes on to show that most of the employment growth came from government or government-supported private sector jobs. Wow!

The Economist Magazine on Church Attendance During the Recession

The Economist's magazine is reporting on how the recession is affecting church attendance and more-or-less concludes there is no evidence of a link. The article, however, has a number of problems. Let me begin with this paragraph:

Last year David Beckworth, an assistant professor of Economics at Texas State University, examined historic patterns in the size of evangelical congregations and found that, during each recession cycle between 1968 and 2004, membership of evangelical churches jumped by 50%. This report filled the newspapers and TV news-shows at the height of the depression panic just before Christmas; but the report’s findings focused on evangelicals, and do not apply to Americans at large.

I did not find membership jumps by 50% during recessions, rather the membership growth rate jumps by that amount. Moreover, while that 50% bump in the growth rate applies only to evangelicals this finding was only part of my study. In fact, the first part of my paper uses a national Pew Survey taken in November 2001 to see if after controlling for evangelicals, 911, and a host of other confounding factors whether one's employment status affects the likelihood of weekly attendance. I found that being unemployed did increase weekly religious attendance in a statistically significant manner.

What my findings show is that one cannot look at the national average and determine if the recession is affecting religious attendance; one has to look at those folks who have been adversely affected the recession to make that call. Frank Newport and the folks at Gallup seem to miss this point. They only look at the headline number and never dig deeper. Gallup simply is not looking at the right data to answer this question. I have not seen John Green's work from Pew Forum on Religion and Public Life, but I suspect he too is looking at the headline weekly attendance number only. I would encourage Frank Newport, John Green, and other interested observers to take a look at my entire paper here.

What makes this frustrating is that I made this point to the Economist's correspondent who contacted me about this story. I have also contacted the folks at Gallup on this same issue back when this issue came up late last year.

Are the Dollar's Days as the Main Reserve Currency Numbered?

Helmut Reisen says maybe:

If history of the last switch in reserve currency (from pound sterling to the US dollar) is any guide, the Chinese renminbi can be expected to replace the US dollar as a reserve currency around 2050.

Reisen notes there are a number of problems in making the transition to the Renminbi as a reserve currency. Therefore, he suggests a modified version of the IMF's Special Drawing Rights could serve as the reserve currency. As I discussed here before, it is not clear to me how this move would eliminate the problems creating the global economic imbalances in the first place. Yes, the SDRs would make it easier for countries holding too many dollars to get out of them, but it would not address the structural and policy reasons why some countries run persistent current account surpluses.

The Deflation Threat of 2009 vs. The Deflation Threat of 2003

Over the weekend, Alan Blinder in the New York Times and Ambrose Evans-Pritchard in the Telegraph both noted that that the real threat currently facing the U.S. economy is not inflation but deflation. One only needs to look at the large negative output gap, the dramatic collapse in nominal spending, or the declines in velocity and the money multiplier to see that there is merit to their claims. There is a real deflationary threat lingering over the U.S. economy in 2009.

With that said, there is an unfortunate irony to the current deflationary threat that can be traced back to 2003. Back then there was another deflationary threat that concerned the Federal Reserve (Fed). As a result, the Fed lowered the federal funds rate to what was at the time an historically low value of 1%. It held this short-term interest rate there for a year before gradually tightening. As we now know, this excessively-loose monetary policy was an important contributor to the buildup of the economic imbalances that eventually led to this economic crisis, including the current deflationary threat. In short, the fear of deflation in 2003 laid seeds for the deflationary threat of 2009.

What makes this an unfortunate irony is that this chain of events did not have to happen. For there was a big difference between the deflationary pressures in 2003 and the ones in 2009. In 2003 the deflationary pressures were driven by rapid productivity gains and were benign in nature. Moreover, nominal spending or aggregate demand was rapidly growing. There simply was no evidence of a malign deflationary threat as there is today and thus, there was no need for the Fed to drop interest rates so low for so long. I have documented these developments in previous posts, but here are a few key graphs that make the case. First, here is the year-on-year productivity growth rate plotted against the ex-post real federal funds rate (click on figure to enlarge):



This pictures shows that Fed was pushing the real federal funds rate into negative territory just as productivity was increasing. The next figure shows final sales to domestic purchasers, a measure of nominal spending in the United States plotted against the federal funds rate. The year 2003 is marked off by the dotted lines (click on figure to enlarge):



No indication here of a collapse in nominal spending in 2003. (There was the weak labor market in 2003, but as I have argued before the slow recovery of employment can most likely be traced to (1) the robust productivity gains and (2) the inordinate substitution of capital for labor given the low interest rates of the time.) What this all means is that the Fed's misreading of the deflationary pressures in 2003 contributed to the creation of deflationary pressures of 2009.

My hope is is that moving forward the Fed and other monetary authorities will be more careful in assessing the sources of and responding to the deflationary pressures.

Balancing Deficit Concerns Against the Need for Stimulus

Scott Sumner provides some fresh perspective:

We do need much smaller budget deficits ASAP, but we also need much more stimulus. How do we achieve these two seemingly incompatible goals? With a much more aggressive policy of monetary stimulus we can get faster NGDP growth, and this will reduce fiscal deficits in two ways:

1. The automatic stabilizer part of the deficit will shrink naturally.

2. There will be less need for discretionary fiscal stimulus.

Yet another reason for monetary policy to target nominal income. Read the rest of Scott's post here.