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Cause for Depression

by Ramesh Ponnuru

A monetary history of our recent economic travails

More than five years into the depression that is the dominating fact of our economy, we still have no clear picture of its causes.

The consensus is that the bursting of a housing bubble was to blame. Borrowers started to walk away from mortgages based on inflated home prices, and financial companies had to write down the value of securities based on those mortgages. That’s what led to the financial panic of late 2008 and early 2009, and the seizing-up of credit markets in turn sent unemployment soaring. This is the explanation to which President Obama alluded in a July 24 speech on his economic agenda.

Many analysts on the left and right accept this basic story but disagree about what caused the mortgage bubble. Conservatives tend to emphasize Fannie Mae, Freddie Mac, and the Federal Reserve’s low-interest-rate policy. Liberals tend to emphasize predatory lenders who tricked people into borrowing more than they could afford, Wall Streeters who took on too much risk, and regulators who allowed all of it to happen. These are not mutually exclusive explanations, of course, so it is possible to mix and match.

Yet it may be that both sides are mistaken, and mistaken precisely in their point of agreement: that the housing boom and bust is the fundamental explanation for our recent economic troubles. It may be that this crisis was indeed brought to us by government policies, but not the ones that the dominant voices on either side of the political divide have in mind.

If so, it will not be the first time that an economic depression was misunderstood by the people living through it. The modern view of the Great Depression, held by almost everyone in the field of economics, is that monetary contraction was the chief cause of the disaster. At the time, though, the prevailing view was that the depression resulted from a stock-market crash and banking crisis that in turn resulted from financial speculation.

Contemporary observers, including most influential economists, certainly did not see extremely tight money as the root cause of the Depression. Indeed, they did not believe that money was tight at all. Interest rates were very low, and the monetary base was growing: both things that many people, then and now, associated with expansive monetary policy. Officials and commentators worried that loosening money — loosening it, they thought, still further — would lead to more of the speculation that had started the calamity.

It was not until decades later, with the 1963 publication of Milton Friedman and Anna Schwartz’s A Monetary History of the United States, that the monetary mistakes of the era were understood. Interest rates were low not because money was loose but because it was tight: Monetary contraction had depressed the economy and thus expected returns to investment. While the monetary base had indeed increased, the collapse of banking meant that the broader money supply, a large portion of which is credit extended by banks, was plummeting. At the same time panic had sent the public’s demand for money balances soaring. So the total amount of dollars being spent in the economy, on either consumption or investment, fell.

That decline raised the burden of debts for borrowers and wages for employers — since it meant fewer dollars coming in to pay either. Businesses went bankrupt; unemployment rose; production dropped. Tight money also crashed asset values, since those values are based on expectations of future income streams that depend on the amount of money being spent. The process fed on itself. Economic contraction led to bank failures and thus to a smaller money supply; rising unemployment and falling stocks led to more panic and thus more money hoarding.

The stock-market crash wasn’t the fundamental cause of the Great Depression: At most it was a sign of the trouble to come. (In 1987 we had a market crash but better monetary policy, and the economy kept humming along.) The bank failures weren’t the cause of it either but a symptom: Economic contraction was well under way before they began.

Cause and effect in the events of the last few years need to be similarly untangled. The timeline does not really fit the standard, housing-centric view of the crisis. The housing market peaked in mid 2006. In his contribution to Boom and Bust Banking, a book on the crash, Scott Sumner summarizes the results for the broader economy over the next few years:

After the housing market peaked in mid-2006, construction of new homes declined steadily for several years. By 2007, prices were falling in many of the so-called “subprime markets” (California, Nevada, Arizona, and Florida). This put increasing stress on the U.S. banking system. By April 2008, the IMF (International Monetary Fund) estimated total losses at $945 billion, and a major investment bank (Bear Stearns) was bailed out by the federal government.

The severe and prolonged housing slump from mid-2006 to mid-2008 did not produce a major recession. Although the business cycle peak was officially dated as December 2007, by mid-2008, unemployment had risen only modestly, and most forecasters continued to predict economic growth ahead. In the second quarter of 2008, real GDP continued to grow. This is how market economies are supposed to work. When there has been overinvestment in one sector (housing), resources should migrate into those sectors that are still booming (services and exports). And that is precisely what did occur for a period of about two years, as the housing sector declined in a very orderly fashion.

It wasn’t until the summer of 2008 that the bottom started to fall out from the economy. All the signs of impending deflation started to appear. Inflation expectations, as measured for example by the difference between the yields on bonds indexed for inflation and bonds not indexed for it, fell. So did commodity prices. The dollar appreciated. The decline in housing prices accelerated and spread. Stocks, which had been falling since autumn 2007, started falling faster.

During this time, Federal Reserve officials nonetheless expressed worry about inflation. Market expectations of future inflation may have been falling, but backward-looking indicators were telling a different story. Energy and food prices had gone up, and so had the Consumer Price Index. (Sumner points out that the CPI ended up grossly overestimating inflation. The calculation of the CPI included an estimate that housing prices had increased from the middle of 2008 to the middle of 2009.)

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. The monetary base rose rapidly as the Fed bailed out the banks — but the overall economy wasn’t given the monetary ease it needed. The inflation that so worried the Fed, meanwhile, never materialized. In the nearly five years since Lehman collapsed and the Fed warned about inflation risks, we have had the lowest inflation rates since the mid 1960s. The forward-looking, market-based indicators turned out to be right.

None of this means that housing was unimportant in the crisis. One of the ways tight money hurt the economy was by making mortgage debts a larger burden than people had expected when they contracted them. A level of debt that seems manageable when nominal incomes are rising 5 percent a year, as they had been doing before the crash, becomes a millstone when incomes are falling. But we could have had a housing-market crash that did not lead to falling total-spending levels and a severe recession. We could not, on the other hand, have had falling spending levels without a severe recession.

During these five years many economists and institutions have been ridiculed for having suggested, beforehand, that the economy could easily handle the decline of housing prices. Yet these forecasts weren’t wrong — or, if they were wrong, they erred only in implicitly relying on the Fed not to botch its job. The common wisdom that “financial crises lead to slow recoveries,” as applied to our economy, also understates the role of the Fed. Instead, very tight money led first to a financial crisis and then to a slow recovery.

Seeing the Fed’s true role in the crisis helps to put some proposals for preventing another crisis in perspective. The financial industry may need to be reformed in various ways, and Fannie and Freddie may need to be unwound. Getting monetary policy right, however, should be a higher priority. And conservatives have a particular stake in this issue.

Our dismal economic experience of recent years has been brought to us by the federal government, which has wreaked havoc through mismanaging the money supply. Yet the public seems to have sided, hazily, with the view that free-market excess was responsible for the dismal economy of the past five years. Hence Vice President Joe Biden could get away, during last year’s vice-presidential debate, with the laughable claim that the sharp recession was the result of the Bush administration’s tax cuts, wars, and prescription-drug benefit. Republican politicians have not thought it worth trying to get the public to change its mind — and have themselves been obsessed by the idea that the Fed is too loose and that inflation is just around the corner.

The failure of the federal government’s tight-money policies has thus abetted the further expansion of that government. It is another unhappy parallel to the 1930s. Let’s hope we do not have to wait until 2042 for a new Friedman and Schwartz.

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