By Scott Sumner
During the Great Recession, many prominent economists told us that we needed to go back to using fiscal policy, as if Congress were competent and powerful enough to steer the business cycle. It is neither. Monetary offset (in 2008, 2009, and 2013) has repeatedly prevented fiscal policy in the US from having the expected effect, and as for competence, Congress just embarked on unprecedented fiscal stimulus at a time of 4.1% unemployment. It’s hard to see how any fair-minded observer could conclude that fiscal policy is effective.
Many experts also discussed the need for “macroprudential regulation” of the financial system. It wasn’t enough to set a fix set of standards, such as a minimum capital ratio—the regulations needed to be tightened during booms and loosened during recessions. And in fairness, policymakers such as the Federal Reserve are not as incompetent as Congress.
Nonetheless, macroprudentiual regulation has failed almost as spectacularly as fiscal policy. As Kevin Erdmann has persuasively documented, the Great Recession led to a sort of “moral panic”, which caused policymakers to crack down on banks. Now that the unemployment rate is down to 4.1%, the Fed has decided that it’s a good time to “fill up the punchbowl”, and it recently announced new regulations to spur lending:
Federal Reserve policy makers seem to be working at cross purposes.
In laying out plans to ease some constraints imposed on banks after the financial crisis, the Fed is moving to free up tens of billions of dollars for financial institutions to lend to promote faster economic growth.
At the same time it is reducing its balance sheet and gradually raising interest rates to restrain credit creation and keep the economy in check.
“The timing is not the most opportune” for relaxing the banking rules, said Mark Zandi, chief economist at Moody’s Analytics Inc. in West Chester, Pennsylvania.
This is the exact opposite of what macroprudential regulation is supposed to look like.
I’ve also frequently discussed the procyclical nature of monetary policy, with the Fed often (not always) running inflation above target when unemployment is low, and below target when it is high. This violates the dual mandate.
Milton Friedman was right about discretionary policies often ending up being procyclical, and indeed to some extent contributing to the business cycle. But in the case of macroprudential regulations, the problem is not exactly the same as with fiscal and monetary policy.
This is just speculation, but perhaps the problem is a sort of knee jerk “this hasn’t been working” mentality. Policy continues under a certain regime for an extended period of time. Then problems develop, and regulators conclude that “this hasn’t been working”. The problem here is that the regulatory regime was inappropriate for the period before the problems developed. Thus in 2009 there was a general sense that tighter regulation was needed. But you can make a good case that it was needed in 2004, not 2009. Similarly, the slow recovery has created a sense that regulations have been too tight. But arguably they were too tight in 2009, not 2018. Policymakers always seem to end up like generals fighting the previous war.