What does it mean to say "The Fed did too much"?
By Scott Sumner
MRU has a video entitled “When the Fed Does Too Much“. That led me to wonder, “too much what”? Too much discretion? Too much regulation? Too expansionary a policy? So I decided to watch the video.
By conventional standards the video is perfectly fine. But then I’m not a conventional economist, and I disagree with several parts of the video.
It begins by discussing the theory that the Fed helped to inflate a housing bubble with a relatively low interest rate policy during the period from 2003-05. Later in the video it suggests that monetary policy is a blunt instrument, and that it might have been better to address the housing issue with regulation rather than with tight money–which affects the entire economy. That was my favorite part of the video. Even later, there is discussion of cases where the Fed did too little, as during the Great Depression. It concludes with a look at whether monetary rules such as NGDP targeting could have prevented the Great Recession.
Here are some reservations that I have with the video:
1. No persuasive evidence is presented in favor of the claim that there was a housing bubble. There is no discussion of the fact that Australia, New Zealand, Canada and the UK all had similar home price run-ups during the housing bubble, or that in those countries prices remained high after 2006. No discussion of the recent sharp recovery in housing prices, which have erased much of the post-2006 decline.
2. There is no discussion of what it would mean to claim that the Fed created the housing bubble. Does that mean there is some other Fed policy that would have prevented a bubble? Or that the Fed adopted a policy that was too expansionary for its own dual mandate, and the bubble was a side effect of that overly expansionary policy? Those are two vastly different claims. For instance, in their discussion of the Great Depression, Alex and Tyler omit any mention of the fact that the Depression was triggered by a tight money policy expressly aimed at restraining a stock market “bubble”. Surely that case is relevant to the issue of whether the Fed should have adopted a more contractionary monetary policy to prevent the 2006 housing bubble!
In the case of 1928-29, the Fed discovered that a somewhat tighter policy was unable to restrain stock prices, and that only a highly contractionary policy that tanked the entire economy was able to end the stock boom. In fairness, this dilemma is alluded to in the part of the video that views the Fed as a blunt instrument, but unfortunately this problem leaves the opening section somewhat incoherent. What would it mean for the Fed to have caused the housing bubble? Would it mean they failed to create a depression? (Presumably not.)
Perhaps that there was some slightly more contractionary policy that would have prevented a bubble, while still keeping us within shouting distance of the dual mandate? (I doubt that would have been possible.)
If the video had been entitled “Was Fed policy too expansionary?”, then the meaning would have been clearer. Then evidence could have been presenting showing inflation and employment data during the bubble period, and comparing the actual performance to the Fed’s dual mandate. Without that data, we have no way of evaluating whether Fed policy helped fuel the bubble.
3. Part of the problem with the opening section is that “monetary policy” is implicitly equated with “interest rate policy”. The authors don’t say this explicitly, but the viewer is led to believe that a more contractionary policy path during 2003-05 would have been a path of higher interest rates. As we saw in the eurozone after 2011, however, that is not necessarily the case. In my view, the adoption of a tighter monetary policy in 2003 would have created a double dip recession (just as in the eurozone) yielding lower interest rates by 2005.
4. The video suggests that a doubling of the money supply in late 2008 was not enough to keep NGDP from falling, and hence that (under NGDP targeting) even more money would have had to be created to prevent a deep recession. Needless to say, this is the part of the video with which I disagree most strongly. Under a regime of 5% NGDP level targeting, the Fed would have been able to keep NGDP growing at an adequate rate with a much smaller increase in the money supply. Interest rates would not have fallen to zero in 2009, and hence the demand for bank reserves would not have risen sharply.
Even worse, there is no mention of the Fed’s creation of a program of interest on reserves during late 2008, which was adopted for the express purpose of sterilizing the injection of new money. The video leaves the impression that the Fed tried to adopt an expansionary policy during late 2008 (with heroic injections of money), but it was not enough. This is simply false. The policy of IOR was adopted because the Fed was worried about high inflation, and hence it is not correct to say the Fed was trying to stimulate the economy when they injected lots of money in the fall of 2008. Indeed the Fed’s justification for IOR cited its contractionary impact. The monetary injections were aimed at helping the banking system, not boosting the economy.
This video presents the events of 2002-08 the way most economists remember things, not the way they actually occurred. I am currently nearing completion of a book manuscript that tells the story of what actually happened in 2008, not what people (wrongly) remember as having happened.
Despite all of these reservations, the MRU video is an excellent teaching tool for giving students an idea of how most economists understand the Great Recession. Beginning students should be taught the standard view, not the heterodox view. (Perhaps after I read Eliezer Yudkowsky’s new book I’ll change my mind on this issue, and become less modest.)
However I hope instructors in more advanced undergraduate courses will supplement this standard view of the crisis with something I have written, once my book comes out. Until then I have some articles available online, including a new paper that just came out in the Journal of Macroeconomics.
HT: David Siegel
PS. I noticed a typo in my Journal of Macroeconomics article:
“Indeed, in March of 2009 the dollar rose 6 cents against the euro on the day that the Fed announced QE1.”
I meant the dollar price of euros rose by 6 cents on the day that QE1 was announced. That means the dollar depreciated. Not sure how I didn’t spot that embarrassing mistake.