Robert Hetzel explains why the real problem was nominal
By Scott Sumner
After I began blogging in early 2009, I started giving talks entitled “The Real Problem Was Nominal.” I argued that tight money, not financial distress, was the cause of the Great Recession.
As far as I know, Robert Hetzel was the only Fed insider who understood this at the time, probably even before I did. Here are some excerpts from his Richmond Fed paper, published in the spring of 2009:
The recession intensified in 2008:Q3 (annualized real GDP growth of −.5 percent). That fact suggests that, prior to the significant wealth destruction from the sharp fall in equity markets after mid-September 2008, the real funds rate already exceeded the natural rate. The huge wealth destruction after that date must have further depressed the natural interest rate and made monetary policy even more restrictive. It follows that the fundamental reason for the heightened decline in economic activity in 2008:Q4 and 2009:Q1 was inertia in the decline in the funds rate relative to a decline in the natural rate produced by the continued fall in real income from the housing price and inflation shock reinforced by a dramatic quickening in the fall in equity wealth.
Indeed it was even worse than Hetzel suggested; revised figures show real GDP falling at a 1.9% rate in the third quarter, and an 8.2% rate in Q4. The following footnote, describing a September 2008 report by Macroeconomics Advisers, also points to the key monetary policy mistakes of mid-2008:
Macroeconomic Advisers (2008b, 1), managed by former Fed governor Laurence Meyer and whose publications discuss monetary policy through the perspective of credit markets rather than money creation, also argued that monetary policy was restrictive: “Over the period that ended in April , the FOMC strategy was to ease aggressively in order to offset the tightening of financial conditions arising from wider credit spreads, more stringent lending standards, and falling equity prices. We said that the FOMC was ‘running to stand still,’ in that those actions did not create accommodative financial conditions but were needed to keep them from becoming significantly tighter. Since the last easing [April 2008], however, the FOMC has abandoned that strategy. Financial conditions have arguably tightened more severely since April than during the earlier period, and yet there has been no policy offset. This pattern has contributed importantly to the severe weakening of the economic outlook in our forecast.”
At the time, people tended to assume that the US recession spread to the rest of the world. Indeed Europeans initially blamed their slump on reckless financial policies in the US. And yet Hetzel points out that real GDP was already falling by the second quarter of 2008 in Britain, Japan and the Eurozone, while in the US real output actually rose in Q2:
In 2008, all the world’s major central banks introduced inertia in their interest rate targets relative to the cyclical decline in output. The European Central Bank (ECB) focused on higher wage settlements in Germany, Italy, and the Netherlands (Financial Times 2008) and in July 2008 raised the interbank rate to 4.25 percent. Although annualized real GDP growth in the Euro area declined in 2008:Q1, 2008:Q2, and 2008:Q3, respectively, from 2.8 percent, to −1 percent, to −1 percent, the ECB began lowering its bank rate only on October 8, 2008. In Great Britain, the Bank of England kept the bank rate at 5 percent through the summer, unchanged after a quarter-point reduction on April 10. From 2007:Q4 through 2008:Q3, annualized real GDP growth rates in Great Britain declined, respectively, from 2.2 percent, to 1.6 percent, to −.1 percent, and then to −2.8 percent. (The Bank of England also lowered its bank rate by 50 basis points on October 8, 2008.) In Japan, for the quarters from 2007:Q4-2008:Q3, annualized real GDP growth declined from 4.0 percent, to 1.4 percent, to −4.5 percent, to −1.4 percent. The Bank of Japan kept its interbank rate at .5 percent, unchanged from February 2007, until October 31, 2008, when it lowered the rate to .3 percent. The fact that the severe contraction in output began in all these countries in 2008:Q2 is more readily explained by a common restrictive monetary policy than by contagion from the then still-mild U.S. recession.
In early fall 2008, the realization emerged that recession would not be confined to the United States but would be worldwide. That realization, as much as the difficulties caused by the Lehman bankruptcy, produced the decrease in equity wealth in the fall of 2008 as evidenced by the fact that broad measures of equity markets fell by the same amount as the value of bank stocks.
Indeed Hetzel points out that financial markets were relatively stable in mid-2008, when the recession intensified dramatically:
Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008. By then, U.S. financial markets were reasonably calm. The intensification of the recession began before the financial turmoil that followed the September 15, 2008, Lehman bankruptcy. Although from mid-2007 through mid-December 2008, financial institutions reported losses of $1 trillion dollars, they also raised $930 billion in capital–$346 billion from governments and $585 billion from the private sector (Institute of International Finance 2008, 2).
I’d add that in mid-2008, most economists were forecasting growth in 2009, despite being well aware of the subprime fiasco. Hetzel also shows that bank lending during 2008 was typical of a recession, despite widespread assumptions to the contrary:
In this recession, unlike the other recessions that followed the Depression, commentators have assigned causality to dysfunction in credit markets. For example, Financial Times columnist Martin Wolf (2008) wrote about “the origins of the crisis in the collapse of an asset price bubble and consequent disintegration of the credit mechanism. . . .” This view implies a structural break in the cyclical behavior of bank lending: In the current recession, bank lending should have been a leading indicator and should have declined more significantly than in past recessions. However, Figure 1, which shows the behavior of real (inflation-adjusted) bank loans in recessions, reveals that bank lending behaved similarly in this recession to other post-war recessions. Moreover, the fact that bank lending rose in the severe 1981-1982 recession and often recovered only after cyclical troughs suggests that bank lending is not a reliable tool for the management of aggregate demand.
Hetzel also criticizes the Fed’s reliance on policies aimed at fixing the credit markets, while ignoring the shortfall in nominal spending (and compares this to the (ineffectual) Reconstruction Finance Corporation of 1932.) In an appendix, he points to a similar misapprehension regarding the Great Depression:
The experience of the Depression casts doubt on the credit-cycle view,
which emphasizes the disruption to real economic activity from the loss of
banks and the resulting loss of information specific to particular credit markets.
Ex-Fed Governor Frederic Mishkin (2008) expressed this idea:
In late 1930…a rolling series of bank panics began. Investments made
by the banks were going bad. . . .Hundreds of banks eventually closed.
Once a town’s bank shut its doors, all the knowledge accumulated by
the bank officers effectively disappeared. . . .Credit dried up. . . .And that’s
when the economy collapses.
However, the implications of this view conflict with the commencement of vigorous economic recovery after the business cycle trough on March 1933 and the occurrence of widespread bank failures in the winter of 1933 and the additional permanent closing of banks after the Bank Holiday in March 1933. During the Bank Holiday, which lasted from March 6 through March 13-15, the government closed all commercial banks, including the Federal 228 Federal Reserve Bank of Richmond Economic Quarterly Reserve Banks. Before the holiday, there were 17,800 commercial banks. Afterward, “. . . fewer than 12,000 of those were licensed to open and do business” (Friedman and Schwartz 1963a, 425). Friedman and Schwartz (1963a, Table 16, 438) list “Losses to Depositors per $100 of Deposits Adjusted in All Commercial Banks.” In 1930, 1931, and 1932, the numbers are, respectively, .6 percent, 1.0 percent, and .6 percent. For 1933, the year in which cyclical
recovery began, the number rose to 2.2 percent.
If banking turmoil was actually such a drag on the economy, why did the US experience explosive growth in 1933, during perhaps the worst banking crisis in American history?
In my view Hetzel’s 2009 paper will eventually be viewed as the definitive contemporaneous account of the mistakes made by monetary policymakers in 2008, as well as the broader misdiagnosis of events by the profession as a whole. I strongly recommend that you read the whole thing. Even better, take a look at his 2012 book entitled The Great Recession. The fact that these studies were produced by someone working within the Federal Reserve System (where not being a team player is highly discouraged), makes them even more impressive.