Yes, the Fed's Errors Made Recession Worse

Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust.

Bold theses should receive skeptical reactions, and ours did. We argued in the New York Times that, contrary to what just about everyone believes, the financial crisis and the Great Recession that blew up the American economy in 2008 were not the necessary consequences of a housing bust. They would not have happened if the Federal Reserve had responded appropriately to increasing economic weakness over the course of that year. Barry Ritholtz (a Bloomberg View colleague), Edward Conard, Mike Konczal and Paul Krugman are among those who criticized our argument. Here we respond.

Things We Did Not Say

Since some criticisms were directed at arguments we didn’t actually make, we should clarify a few things.

First, we are not saying that the right Fed policy would have kept any recession from happening. As we noted, the recession began in December 2007, before the Fed mistakes we discussed: failing to cut interest rates between early April and early October 2008, and even spending much of that time suggesting rate increases were on the way. Our argument, rather, is that these mistakes turned what could have been a mild recession into a “great" one.

Second, we aren't saying that better Fed policy could have prevented serious financial turmoil. Again, we explicitly note that financial stress began before the Fed’s worst errors. Our argument is the errors made that stress much worse.

Third, we aren’t ignorant of the fact that the Fed lowered interest rates between October 2007 and April 2008. We stated it in our op-ed. Again, we were discussing mistakes made after this period.

Fourth, our article did not say that uncertainty about the value of mortgage-backed securities caused the decline of housing prices.

How the Fed Mattered 

By missing these points some of our critics misconstrue our views and make invalid arguments against them. They note, as though it contradicts our story, that Bear Stearns collapsed in March 2008. But that’s entirely consistent with our argument: Stress in the financial sector pre-dated the Fed’s errors, but that stress did not have a severely negative effect on the broader economy. Neither inflation expectations nor nominal spending declined at that time; they declined later, when expected future interest rates rose relative to the natural rate.

Konczal says that the Valukas report on the collapse of Lehman Brothers in September 2008 does not indicate that a looser Fed policy would have staved it off. But here’s what the report says in its introduction: “There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate.” We agree with that assessment. Our view is that raising expected future interest rates was a contractionary move, taken at an especially unfortunate time, and contributed greatly to that climate.

Krugman thinks the behavior of long-term real interest rates contradicts our thesis. They rose in the middle of 2008, but not, he says, catastrophically, as they should have if the Fed were really running a much-too-tight policy. Krugman is incorrect about the implications of our account. We would expect the Fed’s contractionary mistakes to have led to an increase in the risk premium. It did. We would also expect it to reduce the prospects of economic growth and thus lead to a decline in long-term real interest rates adjusted for the risk premium. Again, that’s what happened.

Yes, the Fed Was Wrong

The critics offer different reasons for thinking we are too hard on the Fed. Inflation was “showing unsettling signs of picking up” in 2008, writes Ritholtz, and it’s a “fundamental error” on our part to dismiss the concern the Fed had at the time. But we’re not just applying hindsight: Market expectations of inflation, as measured by TIPS spreads, were declining rather than rising. And those expectations turned out to be correct.

Conard says that monetary loosening in 2008 would not have spurred more lending and would have punished savers. But the decline of lending was an important symptom of the economic crisis, not the cause. Higher nominal income and higher expected nominal income would have increased asset values, which would have increased lending. And savers would have been better off with the higher interest rates they would have received once the economy had strengthened.

Konczal suggests that when Fed officials warned during the spring and summer of 2008 that inflation was rising, they may have helped the economy by increasing the expectations that this would happen. But the Fed’s most powerful way of shaping economic expectations is not by speculating about the future but by indicating what its policy will be. The Fed was signaling that monetary policy would tighten in the future: a contractionary move.

And this brings us to another point. Our critics say or imply that our story just can’t be true: that it’s implausible that the combination of a failure to cut interest rates and some rhetoric about future monetary tightening, even if these were ill-advised, had such disastrous effects. We believe they are thinking about monetary policy too mechanically.

Under most circumstances, the difference for the economy between cutting interest rates and not cutting interest rates would be small. In most circumstances, the difference between taking antibiotics and not taking them would also be small: if, for example, you’re not sick. In certain circumstances, however, the difference is profound.

At a moment of great uncertainty, the Fed signaled that it was more likely to take action to throttle inflation -- a threat markets did not believe existed -- than to prevent a panic. It kept signaling it as that panic grew. And more than signaling: Even after Lehman Brothers collapsed, the Fed’s first policy change was a contractionary one. It started paying interest on excess reserves.

Terminiology, Motives, and Other Distractions

Several of our critics suggest that our argument amounts to saying that the Fed should have prevented a severe recession by taking quicker action, and that we are wrong to say it caused the collapse by tightening money. In truth, we pointed to Fed errors of both omission and commission, but the difference between these types of mistakes does not strike us as especially important in this context. If you don’t turn the ship’s wheel when you’re headed for an iceberg, is that “just” a failure to act?

What matters here is the underlying reality, not the words used to describe it. If our critics come to agree with us that a better Fed policy would have led to a better outcome in 2008, we can agree to disagree on terminology.

Krugman questions our motives. He says that like Milton Friedman before us, we are blaming the Fed for an economic calamity to bolster our laissez-faire ideology. The ideological stakes are not as high, though, as he implies. Even if we are right about the Fed’s responsibility for the Great Recession, it does not mean that, for example, everything was fine in the financial industry and that increasing regulation on it was a mistake. It just means that it is less important to get financial regulatory policy right than we would otherwise have thought, and more important to get monetary policy right.

It is true that, like Milton Friedman, we have views about public policy; it is true that these views are related to one another; and it is true that our political views may have affected our understanding. We daresay all these things are also true of Krugman. Whatever the motives, the arguments have to stand or fall on their own merits. Those merits are strong enough to withstand the criticisms that have been lodged against them.