The debate about the causes of the financial crisis and the great recession will continue for many years, and the facts and analysis that Robert Hetzel put forth in his new book The Great Recession: Market Failure or Policy Failure? should now be part of that debate. As I said in my comments for Cambridge University Press, “Hetzel applies his experience as a central banker and his expertise as a monetary economist to make a compelling case for rules rather than discretion, showing that ‘monetary disorder’ rather than a fundamental ‘market disorder’ is the cause of poor macroeconomic performance. At the same time, he acknowledges and discusses disagreements among those who argue for rules rather than discretion.”a
One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.
In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008. For example, if the Fed had raised the federal funds rate above 1 percent earlier (in 2003 and 2004) then the inflation rate would likely not have picked up as much and the Fed would not have felt the need to take the federal funds rate above 4 percent or keep it high. But in reality the Fed overshot and took the funds rate to 5-1/4 percent and held it there until just before the recession began. This is what I was referring to in Thursday’s Wall Street Journal piece when I said the Fed “overshot the needed increase in interest rates, which worsened the bust.”
Hetzel bases his assessment of policy in 2003-2005 on a policy rule which he calls “LAW (leaning against the wind) with credibility.” Conceptually LAW with credibility differs from a Taylor rule in that interest rate changes are based on changes in GDP rather than the level of GDP compared with potential GDP. (The advantage is that you do not have to estimate potential GDP, which of course is difficult to do.)
In his book, Hetzel suggests that using a LAW rule with a given price stability goal does not indicate that policy was too easy in 2003-2004. However, as he argues on page 197 of the book, the Fed seemed to have relaxed its price stability goal at this time, so in this sense policy may have actually been too easy, and in fact inflation did rise. Hetzel was working at the Fed and thus speaks with considerable personal knowledge. Here is how he puts it:
“In 2003-2004, the Greenspan FOMC did make a decision that would later have enormous implications. At this time, the FOMC backed off its long-run objective of returning to price stability and instead adopted an ill-defined objective of positive inflation, perhaps best characterized as 2 percent plus…. Starting in spring 2004, both core and headline PCE inflation moved persistently above 2 percent…. By summer 2008, that overshoot caused the FOMC to allow a growing negative output gap to persist by holding the funds rate unchanged at 2 percent. If the FOMC had maintained its target for price stability….the sustained inflation shock that began in summer 2004 with increases in energy prices would have yielded lower headline inflation. The FOMC in summer 2008 might have then felt comfortable allowing the inflation shock to pass through the price level while aggressively using monetary policy to deal with the worsening recession.”
So with this interpretation, there is a clear connection between the too easy period and the too tight period, much like the connection between the “go” and the “stop” in “go-stop” monetary policy, which those who warn about too much discretion are concerned with. I have emphasized the “too low for too long” period in my writing because of its “enormous implications” (to use Hetzel’s description) for the crisis and the recession which followed. Now this does not mean that people are incorrect to say that the Fed should have cut interest rates sooner in 2008. It simply says that the Fed’s actions in 2003-2005 should be considered as a possible part of the problem along with the failure to move more quickly in 2008.
In this regard Scott Sumner recently raised some good questions about the part of my analysis on the crisis, where I wrote that one possible unintended consequence of the Fed’s large unanticipated interest rate cut in early 2008 was the decline in the dollar and associated jump in oil and gasoline prices (which were clearly a factor in accelerating the downturn). There were many discretionary moves during this period, but in the part of my analysis Sumner refers to I was discussing interest rates. Recall that on January 22, 2008 the FOMC cut the federal funds rate by 75 basis points in one day, which was most unusual and certainly unanticipated. It was not on an FOMC meeting day, which made it particularly unusual.
The Fed was apparently concerned about stock market turbulence which was later associated with a large trading loss and panic selling incident caused by a single trader Jérôme Kerviel at Société Générale. I was concerned that such a discretionary move tied to stock prices could have adversely affected the Fed’s credibility regarding the dollar and thereby affect oil prices. It was one of many discretionary moves I wrote about, emphasizing that “It is difficult to assess the full impact of this extra sharp easing, and more research is needed” Given that more than four years have transpired, more research is still needed, and I appreciate Scott Sumner raising the issue. In my view the issue is best viewed as only one part of a massive switch away from rules and toward discretion over a number of years, and, as Hetzel’s emphasizes in his book, this is the kind of monetary policy that generally leads to poor economic performance.