The Fed’s er­rors made re­ces­sion worse

The Pak Banker - - OPINION - David Beck­worth

BOLD th­e­ses should re­ceive skep­ti­cal re­ac­tions, and ours did. We ar­gued in the New York Times that, con­trary to what just about ev­ery­one be­lieves, the fi­nan­cial cri­sis and the Great Re­ces­sion that blew up the Amer­i­can econ­omy in 2008 were not the nec­es­sary con­se­quences of a hous­ing bust. They would not have hap­pened if the Fed­eral Re­serve had re­sponded ap­pro­pri­ately to in­creas­ing eco­nomic weak­ness over the course of that year. Barry Ritholtz (a Bloomberg View col­league), Ed­ward Conard, Mike Kon­czal and Paul Krug­man are among those who crit­i­cized our ar­gu­ment. Here we re­spond. Since some crit­i­cisms were di­rected at ar­gu­ments we didn't ac­tu­ally make, we should clar­ify a few things.

First, we are not say­ing that the right Fed pol­icy would have kept any re­ces­sion from hap­pen­ing. As we noted, the re­ces­sion be­gan in De­cem­ber 2007, be­fore the Fed mis­takes we dis­cussed: fail­ing to cut in­ter­est rates be­tween early April and early Oc­to­ber 2008, and even spend­ing much of that time sug­gest­ing rate in­creases were on the way. Our ar­gu­ment, rather, is that th­ese mis­takes turned what could have been a mild re­ces­sion into a "great" one. Se­cond, we aren't say­ing that bet­ter Fed pol­icy could have pre­vented se­ri­ous fi­nan­cial tur­moil. Again, we ex­plic­itly note that fi­nan­cial stress be­gan be­fore the Fed's worst er­rors. Our ar­gu­ment is the er­rors made that stress much worse.

Third, we aren't ig­no­rant of the fact that the Fed low­ered in­ter­est rates be­tween Oc­to­ber 2007 and April 2008. We stated it in our op-ed. Again, we were dis­cussing mis- takes made af­ter this pe­riod. Fourth, our ar­ti­cle did not say that un­cer­tainty about the value of mort­gage-backed se­cu­ri­ties caused the de­cline of hous­ing prices.

By miss­ing th­ese points some of our crit­ics mis­con­strue our views and make in­valid ar­gu­ments against them. They note, as though it con­tra­dicts our story, that Bear Stearns col­lapsed in March 2008. But that's en­tirely con­sis­tent with our ar­gu­ment: Stress in the fi­nan­cial sec­tor pre-dated the Fed's er­rors, but that stress did not have a se­verely neg­a­tive ef­fect on the broader econ­omy. Nei­ther in­fla­tion ex­pec­ta­tions nor nom­i­nal spend­ing de­clined at that time; they de­clined later, when ex­pected fu­ture in­ter­est rates rose rel­a­tive to the nat­u­ral rate.

Kon­czal says that the Valukas re­port on the col­lapse of Lehman Brothers in Septem­ber 2008 does not in­di­cate that a looser Fed pol­icy would have staved it off. But here's what the re­port says in its in­tro­duc­tion: "There are many rea­sons Lehman failed, and the re­spon­si­bil­ity is shared. Lehman was more the con­se­quence than the cause of a de­te­ri­o­rat­ing eco­nomic cli­mate." We agree with that as­sess­ment. Our view is that rais­ing ex­pected fu­ture in­ter­est rates was a con­trac­tionary move, taken at an es­pe­cially un­for­tu­nate time, and con­trib­uted greatly to that cli­mate.

Krug­man thinks the be­hav­ior of long-term real in­ter­est rates con­tra­dicts our the­sis. They rose in the middle of 2008, but not, he says, cat­a­stroph­i­cally, as they should have if the Fed were re­ally run­ning a much-too-tight pol­icy. Krug­man is in­cor­rect about the im­pli­ca­tions of our ac­count. We would ex­pect the Fed's con­trac­tionary mis­takes to have led to an in­crease in the risk pre­mium. It did. We would also ex­pect it to re­duce the prospects of eco­nomic growth and thus lead to a de­cline in long-term real in­ter­est rates ad­justed for the risk pre­mium. Again, that's what hap­pened.

The crit­ics of­fer dif­fer­ent rea­sons for think­ing we are too hard on the Fed. In­fla­tion was "show­ing un­set­tling signs of pick­ing up" in 2008, writes Ritholtz, and it's a "fun­da­men­tal er­ror" on our part to dis­miss the con­cern the Fed had at the time. But we're not just ap­ply­ing hind­sight: Mar­ket ex­pec­ta­tions of in­fla­tion, as mea­sured by TIPS spreads, were de­clin­ing rather than ris­ing. And those ex­pec­ta­tions turned out to be cor­rect.

Conard says that mon­e­tary loos­en­ing in 2008 would not have spurred more lend­ing and would have pun­ished savers. But the de­cline of lend­ing was an im­por­tant symp­tom of the eco­nomic cri­sis, not the cause. Higher nom­i­nal in­come and higher ex­pected nom­i­nal in­come would have in­creased as­set val­ues, which would have in­creased lend­ing. And savers would have been bet­ter off with the higher in­ter­est rates they would have re­ceived once the econ­omy had strength­ened.

Kon­czal sug­gests that when Fed of­fi­cials warned dur­ing the spring and sum­mer of 2008 that in­fla­tion was ris­ing, they may have helped the econ­omy by in­creas­ing the ex­pec­ta­tions that this would hap­pen. But the Fed's most pow­er­ful way of shap­ing eco­nomic ex­pec­ta­tions is not by spec­u­lat­ing about the fu­ture but by in­di­cat­ing what its pol­icy will be. The Fed was sig­nal­ing that mon­e­tary pol­icy would tighten in the fu­ture: a con­trac­tionary move. And this brings us to an­other point. Our crit­ics say or im­ply that our story just can't be true: that it's im­plau­si­ble that the com­bi­na­tion of a fail­ure to cut in­ter­est rates and some rhetoric about fu­ture mon­e­tary tight­en­ing, even if th­ese were ill-ad­vised, had such dis­as­trous ef­fects.

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