Cruz vs. the Fed

by Ramesh Ponnuru

Senator Ted Cruz is the most prominent politician, indeed the most prominent person, to make the claim that the Federal Reserve made the economic crisis of 2008-9 much worse by tightening monetary policy in mid-2008. It’s a claim with which I agree.

In The Week, Jeff Spross argues against Cruz. He acknowledges that monetary economist David Beckworth has backed the senator on this question. But the natural or equilibrium interest rate went negative during the crisis, and the Fed could not set its target interest rates significantly below zero. Nor could it reliably make up for its inability to go below zero by engaging in quantitative easing. Thus it is unreasonable to hold the Fed primarily responsible for the crisis.

Spross notes that Cruz has argued for a more rule-bound Fed, and he concedes that one kind of policy rule that has been urged on the Fed might have helped: If it had adopted the goal of stabilizing the growth of nominal spending, it might have engaged in more quantitative easing and helped the economy recover faster. But Cruz, he notes, has been against quantitative easing.

It’s reasonable for Spross to be skeptical about a Fed-centric theory of the economic crisis; not a lot of people accept it. But I think he has gotten that theory wrong in important respects. Beckworth and other “market monetarists” believe that if the Fed had credibly committed to keeping nominal spending on a stable path, the natural interest rate wouldn’t have gone negative in the first place. The rule would have worked in large part by stabilizing expectations. What the Fed got wrong in 2008 wasn’t just that it didn’t lower its target interest rates rapidly enough to chase the natural interest rate downward; it’s also that its tardiness and its signaling that it was concerned about a non-existent threat of inflation pushed the natural rate downward.

Spross’s notion that a nominal-spending rule might have been useful because it would have led to more quantitative easing is almost exactly the reverse of what market monetarists tend to think: The adoption of that rule would have led to less quantitative easing, and less need for it.

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