The Corner

Republicans and the Fed

I have a column at Bloomberg going through the Republican presidential candidates’ statements about monetary policy during this week’s debate–arguing that most of their criticisms are wrong, and trying to explain where they go wrong. Here, though, I want to expand on something I tweeted during the debate: Cruz made a point that few people do, which is that the Federal Reserve made the economic crisis much worse by tightening money in 2008. Cruz has received some pushback over this assertion, but he’s right. The Fed was too loose in 2003-6, as he suggested, and too tight in 2008-9. I went into this history in NR a while back:

One way monetary policy affects the economy, and arguably the crucial way, is by shaping expectations. When the Fed creates an impression about future spending levels, it affects the spending that people undertake today in anticipation of that future. So when the Fed suggests that it will pursue a tighter policy in the future, it is effectively tightening money in the present. Even when it cuts the federal-funds rate, it may be tightening money if markets had projected a sharper cut.

By mid 2008 the Fed had been effectively tightening for months. In December 2007 the Fed cut the federal-funds rate by less than markets had expected. During the summer Fed officials made inflation-phobic comments that led informed market participants to expect a tighter policy in the future. The minutes of the August 2008 meeting declared that “members generally anticipated that the next policy move would likely be a tightening.” Current policy was “passively” tightening as well: As the economy deteriorated, the distance between the looseness it needed and what the Fed was providing increased.

Even after Lehman Brothers collapsed in September 2008, the Fed refused to cut the federal-funds rate and issued a statement citing the risks of inflation. Market expectations of inflation fell further. The Fed would not cut rates until October 8, weeks after the crisis had started to dominate the news — and even that decision followed a contractionary move, the October 6 decision to pay banks interest on excess reserves, which discouraged bank lending.

Markets had no reason to have any confidence that the Fed would continue to keep total spending throughout the economy rising at a steady rate, as it had more or less done for the previous quarter-century. Indeed, spending started to fall in June 2008, months before Lehman’s collapse, and ended up declining at the fastest rate since “the recession within the Depression” of 1937–38. Tight money — that is, reduced expectations of future spending — made everything worse. It depressed asset prices and raised debt burdens, adding to bank losses and making households more fearful about spending.

Housing did not cause the financial crisis, in other words. The Fed did. The Fed may not have caused the recession, but its excessive tightness caused what could have been a mild recession to become the worst one since the Great Depression. And as in the Depression, most observers did not see that the Fed was being tight at all.

Cruz was also right, in my view, to suggest that the Fed has too much discretion and should set policy by a predictable rule. (I don’t, however, think he is right about the rule it should follow: He seems to want it to try to stabilize the price of gold, which seems like it would force American wages and prices to adjust en masse to shifts in the demand for jewelry in Asia.)


Ramesh Ponnuru is a senior editor for National Review, a columnist for Bloomberg Opinion, a visiting fellow at the American Enterprise Institute, and a senior fellow at the National Review Institute.


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