Rashomon in 2008
By Scott Sumner
There’s a classic Japanese film where four different viewers see the same event in four different ways. I am reminded of this when I consider all the different ways in which the events of 2008 are interpreted. Obviously you have Keynesian, monetarist and Austrian views, as well as MMT, new classical, and many others. And even within the Keynesian tradition, there are numerous perspectives. Here’s Paul Krugman discussing Ben Bernanke:
There’s an economic dispute underway about the causes of the Great Recession . . . on one side you have Dean Baker, who has long argued that the burst housing bubble was the main factor in both the slump and the slow recovery, with financial disruption a minor and transitory factor — a view I mostly agree with. On the other side we have none other than Ben Bernanke, who argues in a new paper that credit market disruption was indeed the big story.
I believe they are both right, and both wrong. In both cases, the criticism of the alternative view is persuasive. For instance, Krugman’s right that Bernanke’s view doesn’t explain the persistence of the Great Recession:
I have trouble seeing the “transmission mechanism” — the way in which the financial shock is supposed to have affected actual spending to the extent necessary to justify a finance-first account of the slump.
Let me focus specifically on investment, which is what you’d expect a credit crunch to depress — and which did indeed plunge in the Great Recession. First, there was the housing bust, which led to a huge decline in residential investment, directly subtracting around 4 points from GDP:
So can we attribute this decline to credit conditions? If so, why did residential investment remain depressed five years after credit markets normalized?
I would add that the failure of Lehman occurred nine months into the recession, and several months into the most intense phase of the recession.
But Krugman’s housing view also has problems, as the housing slump had been occurring for 2 years before any significant increase in unemployment. The unemployment rate inched up from 4.7% in January 2006 to 5.0% in April 2008, even though by the latter date we’d already lost 3 of the 4 percentage points of GDP from depressed residential investment.
If I were to defend their two hypotheses, I’d make essentially the same argument in both cases. Both the housing slump and the credit crunch had the effect of reducing the Wicksellian equilibrium interest rate. Thus in both cases, the Fed needed to reduce their target interest rate in tandem with the falling equilibrium rate in order to prevent a severe recession. During 2007 and early 2008 they did this, but then the equilibrium rate fell increasingly far below the policy rate (then 2%.)
In the end, I don’t find these explanations to be satisfactory, partly because I don’t share the same view as Krugman and Bernanke on what it means to say monetary policy caused something to happen. I don’t see the Fed as a helpless bystander, which might or might not act to prevent sharp changes in NGDP caused by exogenous shocks, but rather as being more like the captain of a supertanker, who has a duty to steer the nominal GDP of the economy.
One can argue that this metaphor is inappropriate at the zero bound, but the US was not at the zero bound during 2008. Indeed rates didn’t even fall to 0.25% until mid-December of 2008. Thus the severe slump in NGDP during the second half of 2008 represented the outcome of an explicit Fed policy. One can try to defend the Fed using arguments such as “recognition lags”, etc., but the merely redefines the type of mistake that was made, not the source of the problem.
Unless I’m mistaken, the asset markets, Paul Krugman, and I all agree on one point; policy was clearly too tight in the second half of 2008, and that fact was obvious at the time. In his memoir, Bernanke also acknowledges that policy was too tight in the period after Lehman failed.
I’m guessing that Krugman and Bernanke would not agree with my claim that a more expansionary policy during 2008 would have been sufficient to prevent a severe recession, or at least that a more expansionary conventional monetary policy would have been sufficient. In turn, I reject the notion that interest rates should be viewed as “conventional policy”. In my view, open market operations (including QE) should be regarded as conventional monetary policy, and interest rates are one of many possible short run targets. I would add that (because of the zero bound issue) interest rates are one of the least effective policy targets.
The Great Recession would not have been “great” if any two the following three steps had been taken in early 2008:
1. A policy of 5% NGDP growth, with level targeting to correct short run deviations from the trend line.
2. A policy of targeting the market forecast of NGDP.
3. A “whatever it takes” approach to open market operations, which means buying whatever quantity of assets that is necessary to keep expected future NGDP equal to the policy target.
Instead of adopting at least two of these three highly effective policy tools, the Fed adopted zero of the three. That’s why the recession was so deep.
PS. My hunch is that Bernanke would have favored the level targeting option (at least for prices), but could not get support from within the Fed. I’m not sure of his views on the other two policy tools.
PPS. Holman Jenkins of the WSJ seems open to alternative perspectives on 2008:
What bubble there was seemed confined to a few subprime hot zones mainly in the West and Southwest. Now comes the Mercatus Center’s Kevin Erdmann to complicate the story. The hottest markets in the country never stopped being hot because restrictive zoning and building regulations turn them into what he calls “closed-access cities,” such as New York and San Francisco, where it is legally impossible to supply the housing demanded by the nonrich. . . .
He also shows, based on rents, construction and housing’s share of personal consumption, there never was a national oversupply of housing but the opposite: a shortage that continues today, centered on the closed-access cities that generate so much of U.S. economic activity.
Every day the sun rises in the world capital markets on countless scenes of failed risk-taking without causing a general panic. This is where the housing story interacts with another strand of revisionism, led by Bentley University’s Scott Sumner, which faults the Ben Bernanke Fed for tightening all through the Great Recession, oblivious to plunging inflation and a rising public demand to hold cash.
Here’s the great Toshiro Mifune, star of Rashomon:
HT: Marcus Nunes, Kate DeLanoy, Ben Klutsey