Magazine September 10, 2018, Issue

Rethinking the Recession

(PW Illustration/Getty)
Blame the Fed’s monetary policy.

Everyone knows that the collapse of a housing bubble led to a financial crisis and a severe recession ten years ago. There is, to be sure, some disagreement concerning important details of what happened. The dominant understanding, favored by liberals, emphasizes predatory mortgage lenders, reckless Wall Street bankers, and see-no-evil regulators. Conservatives have sought to place government subsidies for imprudent lending and borrowing in the housing market at the center of the story. Everyone agrees, though, that a boom and bust in housing was the central event from which disaster rippled.

But what if everyone is wrong? What if instead mistakes by the Federal Reserve were the key cause of the economic crisis, without which it would not have happened? And what if the mistakes persisted in a way that kept the recovery weaker than it had to be?

That view is held by a group of “market monetarist” economists who have argued that the Fed, by running an excessively tight policy (specifically by letting spending levels throughout the economy fall), converted a housing correction into a housing crash, financial stress into a financial crisis, and a mild downturn into the worst recession we have had since the 1930s. They have argued further, also contrary to the received wisdom, that the Fed kept policy too tight during the early years of the recovery and thereby prevented a stronger rebound.

The tight-money theory fits the timeline of the economic crisis better than the housing-centric one does. The housing sector began to slump more than two years before the crisis hit, in 2006. Employment in construction dropped in 2006 and 2007, but employment overall continued to grow, as did economic output. The National Bureau of Economic Research would eventually determine that a recession started in December 2007, but even into the next spring it looked as though resources were shifting from housing to other sectors without the economy’s having to suffer vast damage.

The housing slump caused uncertainty about the value of bonds tied to subprime mortgages. Institutional investors that used those bonds as collateral started to pull money out of financial firms. But the stress to the financial system appeared to be manageable. It has been estimated that only 6 percent of banking assets were connected to subprime mortgages in 2007.

A number of economic indicators began to turn sharply south only in the spring and summer of 2008, which is also when, according to the market monetarists, the Fed embarked on its mistaken course.

There are two ways of telling that story. It has become conventional to think and speak of monetary policy in terms of interest rates, and specifically in the U.S. of the target that the Federal Reserve sets for the federal-funds interest rate it charges to member banks. The Federal Reserve raises this rate when it seeks to fight inflation and lowers it to forestall or ameliorate recessions. In the version of the tight-money story that focuses on interest rates, the Fed’s error was to keep interest rates and expected interest rates too high during the crucial months.

The Fed lowered interest rates between September 2007 and April 2008, when we now know the mild phase of the recession began. But it then kept the rate at 2 percent from April through early October. Since the economy was weakening, however, the “neutral” or “natural” interest rate — roughly, the hypothetical rate that neither stimulates nor contracts the economy — was falling. If the interest rate is at 2 percent while the natural rate is falling below it, the gap between the two is rising and policy is getting steadily tighter.

And Fed officials spent much of the spring and summer signaling that higher interest rates were on the way. They were worried that rising oil prices would lead to inflation, even though changes in the relative yields of Treasury bonds that are adjusted for inflation and those that are not indicated that market expectations of inflation were falling. They were led astray in part by one of their measures of inflation, “core CPI” (the Consumer Price Index minus food and energy costs). It was elevated, but it badly mishandled housing prices, which it treated as rising in a year when they were actually falling.

Even after Lehman Brothers collapsed on September 15, 2008, causing a 504-point (or 4.4 percent) drop in the Dow Jones index of stocks, the Fed declined to lower interest rates. It issued a statement citing the risk that inflation would rise. On October 6, the Fed actually adopted a contractionary policy, deciding to pay banks interest on excess reserves. The goal of this policy was to keep efforts to recapitalize the banks from having spillover inflationary effects on the wider economy. It wasn’t until October 8 that the Fed finally cut rates.

Market monetarists do not, however, think about monetary policy primarily in terms of interest rates. They prefer to think of it in terms of the path of total spending levels throughout the economy (including both consumption and investment). They think that the Fed should keep the amount of spending growing at a steady, predictable rate: something it had done fairly well during the two decades prior to the Great Recession, a period of macroeconomic peace that had come to be called the “great moderation.” Spending rose by 5.3 percent each year, on average, and did not fluctuate much around that average. (The fraction of that increase that represented inflation, and the fraction that came from economic growth, varied with productivity.) That steady rate formed a backdrop of stability, enabling households and businesses to make and coordinate their economic plans.

In the middle of 2008, however, spending was falling. By declining to reduce the federal-funds rate and saying it might need to rise to counter inflation, central bankers were not just discouraging borrowing. At least as important, they were signaling that they were not going to bring spending back up to its customary growth rate and would instead exert further downward pressure.

When spending falls below expectations, it means that in­comes also fall below expectations, for households and businesses. When expected future income streams are adjusted downward, the value of assets — be they stocks, houses, or bonds tied to mortgages — falls, too. The burden of paying debts and making payrolls rises. Homeowners default on their mortgages, and employers make layoffs.

If a central bank does not take drastic action in these circumstances, vicious circles can begin. The expectation of lower income in the future further depresses spending in the present. Layoffs reduce it, too. Financial firms that would have been stressed in a weak economy become insolvent in a declining one — and the headlines about them spark a panic that makes people less willing to consume or invest.

The housing-centric story of the economic crisis was able to become the standard one because it is assembled from many truths. It just configures them the wrong way. House prices did fall calamitously. Their fall inflicted a lot of pain, and the consequences ramified through the financial system and economy. But we could have had a decline in the housing sector without a deep recession. That’s what we were having before mid 2008. It’s what Australia had around the same time; it followed a steadier monetary policy and underwent only a mild correction. We could not have had a sudden drop in spending, on the other hand, without a housing bust and a sharp recession.

By the height of the crisis, spending was falling faster than it had since the “recession within the Depression” of 1937–38. That fact should be understood, much more widely than it is, as a failure of the Federal Reserve.


In many retellings of the history of the crisis, the Fed is credited for taking drastic action, in concert with the Bush and Obama administrations, to rescue the economy. These retellings, needless to say, do not mention how much the Fed did to cause the turmoil in the first place. They also grade the Fed’s performance during the recovery too generously.

By any reasonable standard, monetary policy in the early years of the recovery was too tight. Consider it first from the standpoint of total spending. A Fed that aimed to stabilize total-spending growth over the long run would compensate for missing its target in one period by missing it in the other direction during the next one. So if it was trying to keep spending rising at 5 percent, and instead it rose at 4 percent in one year, it would aim to have it rise by 6 percent the year after. But spending did not rise back toward the pre-crisis trend line during the recovery. It did not rise even at its pre-crisis rate — which meant that the gap between the post-crisis path of spending and the path it had followed previously kept rising.

One need not focus on spending growth to see that money was too tight. By statute, the Fed is supposed to try to keep both unemployment and inflation at a low level. High unemployment is a reason to loosen monetary policy, high inflation a reason to tighten. The Fed had long informally adopted an inflation target of 2 percent per year and made it explicit in 2012.

For nearly the entirety of the last ten years, however, inflation, according to the Fed’s preferred measure, has been below that target. During the early years of the recovery, unemployment was higher than anyone considered acceptable. Higher-than-target unemployment and lower-than-target inflation should have been considered a clear sign that money was too tight and needed to be looser. Yet the Fed rarely acted on that understanding and often debated opting for tighter money. It would eventually raise interest rates, in December 2015, while inflation (and market expectations of inflation over the next ten years) remained below 2 percent.

Yet it was not uncommon over the past decade for the financial press to refer to the Fed’s “ultra-accommodative” monetary policy. Prominent conservatives warned that this policy risked runaway inflation, a risk that did not materialize. The confusion arose because the Fed kept interest rates low by historical standards and, through several rounds of “quantitative easing,” expanded its balance sheet. Yet neither of these measures is a reliable gauge of whether money is loose or tight.

Economists these days commonly accept that money was very tight in 1930, for example, even though interest rates were much lower than they had been in the 1920s. The great monetary economist Milton Friedman made the point that low interest rates can even be a symptom of extremely tight money: When a central bank has choked the life out of an economy, the natural interest rate will be depressed. Many estimates of the natural rate during the early years of the recovery suggested that it was negative, which means that even a low positive rate was not stimulative.

The Fed could certainly have been tighter: if it had raised interest rates more precipitously, for example, as the European Central Bank did, to the Continent’s detriment, in 2011. But the Fed’s apparently accommodative policies were more limited than they appeared to be. It signaled that the expansion of the monetary base would be temporary, and markets took it as such. The Fed continued to pay above-market rates on banks’ excess reserves, dampening the stimulative effect of the increased supply of bank reserves on the economy.

Since most conservatives and liberals shared the view that the Fed was already running a highly expansionary policy, neither group pushed for stronger measures. Political constraints aside, such measures were always available: The Fed could have stepped up the pace of its asset purchases, or announced a goal of higher inflation or total spending, or lowered the interest it paid on excess reserves.

But conservatives thought that a looser monetary policy would be dangerous, because inflationary. Many liberals, meanwhile, thought it would be ineffective. In November 2008, President-elect Obama told one of his economic advisers, “It’s clear monetary policy has shot its wad.” When vacancies arose among Fed policymakers, Obama sometimes failed even to nominate replacements.

Liberals, including Obama, thought that combating the recession required additional fiscal rather than monetary action. The argument for fiscal stimulus — which is to say, for higher deficits — made sense only to the extent that monetary policy was assumed to have reached the limit of its effectiveness. Obama’s theory, after all, was that either economic production or prices or both would be significantly higher with fiscal stimulus than without it. Without the stimulus, then, output and prices would have been significantly lower. In that case, presumably the Fed would have acted more vigorously to keep the economy from sliding into a 1930s-style depression.

There were two major economic rationales for prioritizing fiscal stimulus over urging the Fed to do more. One was the conviction that the Fed could not do anything more, even though, as noted, there were several steps it had not attempted to take. Another was the hope that federal spending would be deployed in especially productive ways.

By the same token, liberal fears about the “austerity” that came after Republicans took over Congress were misplaced. The start of Obama’s second term was an almost perfect illustration of the way monetary and fiscal policy interact. Negotia­tions between Obama and Republicans in Congress resulted in a tax increase and spending restraint. Partly in response, the Federal Reserve took measures to loosen monetary policy. The economy did not fall into another slump, as some economists had feared.

And it has, with painful slowness, recovered. It was a mistake for the Fed first to let spending fall and then to content itself with slower spending growth than the pre-crisis trend line. But it has at least kept the new, lower pace steady. Over time, the economy has adjusted to it. (People who take out mortgages today are on average doing so with the implicit expectation that their incomes will grow at a slower rate than the home-buyers of 2005 thought.) But the cost of the crisis and the weakness of the recovery — in a loss of wealth, in political instability, even in a lowering of birth rates — has been immense.

The same was true, on a much larger scale, of the Great Depression. It too was not well understood as it happened, and even afterward. Until at least the publication of Milton Friedman and Anna Schwartz’s Monetary History of the United States, in 1963, the prevailing explanation of the Depression treated non-monetary factors such as stock-market speculation and banking problems as its major causes. Now we take for granted the centrality of monetary tightness to the Depression.

A similar reevaluation of our more recent economic misfortunes, with greater attention to monetary dysfunction, is in order. That reevaluation need not conclude with the wholesale rejection of other ideas about the crash. It may be that conservatives are right about the oversubsidization of housing, or that liberals are right about the deficiencies of financial regulation, before the crisis. We can also continue to debate whether the federal government handled Bear Stearns and Lehman Brothers appropriately in 2008. But we should consider whatever other policy errors were made, of omission and commission, to be secondary to the great monetary failure of our era. That failure was avoidable, and until we come to grips with it, a reprise is all too possible.

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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