George Selgin has a new post discussing a paper he wrote with David Beckworth and Berrak Bahadir. In the paper they argue that the Fed set its policy rate too low during the early 2000s, and that this decision contributed to the subprime boom:

It is widely believed that, in the wake of the crash, the Fed kept the federal funds target rate too low for too long, inadvertently contributing to the subprime boom. We attribute this and other Fed departures from a “neutral” policy stance to the Fed’s failure to respond appropriately to exceptional rates of total factor productivity growth. We then show how the Fed, by adhering to a nominal GDP growth rate target, might have succeeded in maintaining such a neutral stance.

This is certainly a defensible claim, and I agree with the policy implications they draw from their analysis. Nonetheless, I am going to offer a few words of caution:

1. We should never leave the impression (even unintentionally) that sound monetary policy will prevent severe sectoral imbalances. It’s quite possible that a housing boom of almost equal size would have occurred during the early 2000s, even under a perfect NGDP targeting policy.

2. It’s dangerous to focus on interest rates, even if everyone else in the world insists on talking about monetary policy in terms of interest rates.

Here are some other claims about the housing “bubble” period, that I would argue push a little bit back against the view that the Fed played an important role:

1. Low interest rates don’t imply easy money, unless it can be established that they were below the Wicksellian equilibrium rate. And this can only be determined by looking at NGDP growth rates.

2. NGDP growth during the 2001:4 to 2007:4 expansion averaged well under 6%. At the time it was the lowest growth rate during any economic expansion since NGDP data collection began in the 1940s. In retrospect, NGDP growth during the early 2000s expansion probably should have been even less. However I’m reluctant to attribute major economic events to excessive NGDP growth in an economic expansion, when NGDP growth during that expansion was unusually slow.

3. Monetary policy is not a surgical tool that can be used to affect specific sectors of the economy. It can only affect any given sector by affecting the overall economy (NGDP.) Thus in 1928 and 1929 when the Fed tried to use higher interest rates to slow the stock market boom, and the policy was a complete failure until rates were raised so high that NGDP began plunging. Then stocks crashed. It wasn’t the high interest rates, it was the falling NGDP. If Fed policy contributed to the subprime boom, it was not from low interest rates, but rather excessive NGDP growth.

4. If the Fed’s policy had aimed at slightly slower NGDP growth during 2001-07, then interest rates in the counterfactual policy would have been a bit higher in 2001-02, but substantially lower in 2003-07. In the long run rates tend to follow the economy, and that is why slower NGDP growth in 2001-07 would have implied lower interest rates by 2003-07. That’s something to think about if you believe low rates fed the housing boom by making mortgages “affordable.”

5. Even under an ideal monetary policy, the subprime boom might have occurred due to Federal government policies aimed at boosting mortgage lending (FDIC, GSEs, TBTF, CRA, etc.) and/or mistakes made by private sector lenders. There doesn’t seem to be much correlation between easy money and what are viewed as “bubbles,” indeed bubbles were noticeably absent in the Great Inflation of 1966-81, and the 1928-29 stock boom occurred during a period of mild deflation and extremely high real interest rates. (In fairness, NGDP growth was probably reasonably good in 1928-29.)

None of this should be viewed as criticism of the key analytical points in their article. Fed policy is too expansionary during periods of rapid productivity growth because the Fed focuses on inflation, rather than NGDP growth. With a policy of NGDP targeting, level targeting, the past 15 years would have been far more stable. However in my view that extra stability would come more from easier money after 2007 than tighter money before 2007.

PS. I put the term “bubble” in quotation marks because I don’t really believe in bubbles. I’m referring to periods that other people view as bubbles.