J'accuse

Further thoughts on the Great Recession

My previous post began with the Wittgenstein quote about the Earth rotating. Many commenters seemed to have missed the point. At first glance it certainly looks like the Great Recession was caused by the financial crisis. But the recession more closely resembled what you’d expect if it were caused by tight money in the US and even tighter money in Europe. In this post I’ll extend a few of my arguments, and then explain why I insist on what some view as an inappropriate use of the term caused.

Commenters cited a myriad of things that went wrong with our financial system in the lead-up to what came to be called the “Global Financial Crisis.” But my post wasn’t about the GFC, it was about the Great Recession. The post focused on showing how the Great Recession was caused by tight money, not by the financial crisis. I don’t doubt that The Big Short is full of fascinating observations about our financial system, but that wasn’t the topic of the post.

Here’s an analogy. During February and March of 1933, the US experienced that worst banking crisis is US history. Many banks remained shut down for much of 1933. So how did the economy do? Industrial production rose 57% between March and July 1933, the fastest rate in US history. That’s because the US also had the most expansionary monetary policy in US history—a sharp devaluation of the dollar after more than 50 years of pegging at $1 = 1/20.67 ounces of gold. Monetary policy drives the business cycle, not financial turmoil.

If you read my critics, you would have assumed that the economy did poorly during March through July 1933. You would also assume that there’s nothing that monetary policymakers could have done with thousands of banks shut down and interest rates stuck at zero. Neither statement is true. Monetary stimulus more than offset the worst banking crisis in history.

The GFC was not the Great Recession; they were two distinct events. Here’s Wikipedia discussing the 2023 banking crisis:

The New York Times said that the March banking crisis was hanging over the economy and had rekindled fear of recession as business borrowing would become more difficult as many regional and community banks would have to reduce lending.

Fear of recession in 2023? Nevermind.

Just as many commenters overlooked the Wittgenstein quotation, they seemed to overlook my observation that the Great Recession was significantly worse in Europe than in the US, even though the financial crisis occurred here and despite the fact that pundits initially expected the US to suffer much more than Europe.

Even though the European economy is about the same size as the US economy, and the recession was worse over there, I don’t recall a single comment on what caused the European recession (which began years before the Eurozone crisis). If you have a theory about how the entire mess was caused by sub-primes, or CDOs, or MBSs, or AIG, or rating agencies, or a dozen other factors, why did these American problems cause a Great Recession that was worse in Europe? Perhaps because monetary policy was tighter in Europe?

I understand that analogies such as a bus going off the road don’t prove anything. I used the analogy to illustrate my use of the term caused. Some commenters objected to this term, with the best argument coming from Philippe Bélanger:

For what it's worth, I don't think that is the crux of the issue. Even if it's true that the Fed could have prevented the 2008 recession (and I think it could have), it doesn't follow that if the Fed had adopted a different policy, it would have adopted the one that would have prevented the recession. It could, for example, have adopted a much worse policy that the one it did follow. So the counterfactual "different policy, no recession" is not straightforwardly true.

More generally, I think we are in agreement that the important issue is whether the Fed could have prevented the recession, and if so, how. Whether the Fed caused the recession in some metaphysical sense is not a very interesting question, unless you are the kind of person interested in having abstract discussions about the philosophy of causation.

In general, I agree that pointless philosophical debates are a waste of time. In this case, however, I would insist that the term “caused” is quite useful. To see why, think of three levels of belief about monetary policy:

1. General Public: Inflation is not a monetary process. The Fed can have some impact on inflation, but only as a series of gestures.

2. Most economists: The Fed determines the long run trend rate of inflation and has some ability to moderate the business cycle. But the Fed is not able to prevent severe recessions like 2008-09, triggered by financial distress.

3. Me: While the Fed cannot completely eliminate quarter by quarter volatility in NGDP growth, with two policy changes we could dramatically reduce the volatility of the business cycle. These two innovations are level targeting and market guidance of monetary policy.

In everyday life, our willingness to blame bus drivers or ship’s captains for accidents depends on our perception of whether we believe it was reasonable to assume that with appropriate behavior they would have avoided the accident.

I believe that with appropriate policy reforms an event such as the Great Recession would be just as avoidable as something like hyperinflation. We all know that if the Fed were to suddenly start printing money like crazy and generated 100% annual inflation, then most economists would blame the Fed for causing the inflation. So it’s not like the term “caused” is never appropriate for macroeconomic policy mistakes. The question is where to draw the line. When is finger pointing appropriate?

If I had a mainstream economist’s view of the efficacy of level targeting and market guidance to monetary policy, I would agree that it would be inappropriate to claim the Fed caused the Great Recession. But most economists underestimate what good monetary policy is capable of achieving. When I use the term ‘caused’ I am trying to shake people by their shoulders, to get them to realize that a better monetary policy is possible. As Keynes once said:

“Words ought to be a little wild, for they are the assaults of thoughts on the unthinking.”

Under this improved monetary regime there would be widespread agreement that an NGDP plunge like 2008-09 represents an avoidable policy mistake, and hence that the Fed caused the recession, or at least made it vastly worse. (A very small recession might have occurred even with the optimal policy.)

In other words, I have a very heterodox view of how monetary policy works. If I am correct, then the phrase caused the recession is appropriate. If the mainstream view of money/macro is correct, then my use of the term ‘caused’ is inappropriate.

Unfortunately, there is no silver bullet, no single piece of evidence that clinches my argument. If only life were that simple! Instead, macro is like a giant jigsaw puzzle, where the picture becomes clearer and clearer as more pieces are put into place.

After my talk at Less Online, I received many questions. The most challenging comment pointed to the fact that Japan’s real GDP growth did not increase significantly after Abe was elected in January 2013. In my view, this is due to several factors. First, Japan’s population has fallen by about 3 million since the beginning of 2013. Second, although Japan had already suffered from two decades of mild deflation, their labor market had mostly adjusted by 2012. Unemployment was only 4.2% at the time Abe took office. And nominal GDP pretty clearly improved after Abe adopted monetary stimulus:

Even if RGDP didn’t accelerate, growth in NGDP helped to improve the job market and also eased Japan’s enormous public debt problem. The unemployment rate under Abe was lower than during the previous two decades of mild deflation:

My claim that things improved under Abe is not particularly controversial. Even economists that disagree with my claim that tight money caused the Great Recession generally saw Abe’s monetary policy as improving Japan’s economy by boosting aggregate spending. Paul Krugman wrote an entire paper making this claim.

I worry that readers may not have paid enough attention to natural experiments that support my arguments. Let’s take a close look at another example. In late 2012 we were approaching a “fiscal cliff”, as Congress was set to cut spending and raise taxes, with the changes taking effect at the beginning of calendar 2013 (not the more usual fiscal year). The Fed came to the rescue with a package of monetary stimulus that included both a new QE program and much more aggressive forward guidance. (Albeit still far too little in my view.) The day after, I had my Andy Warhol moment:

Business Insider:

Meet The Blogger Who May Have Just Saved The American Economy

By Joe Weisenthal

The Atlantic:

The Blogger Who Saved the Economy

By Derek Thompson

Slate:

The Scott Sumner Rally

BY MATTHEW YGLESIAS

Marginal Revolution:

It’s not just monetary policy, it’s Scott Sumner day

by Tyler Cowen

Unless I’m mistaken, most of these people do not agree with my claim that the Fed caused the Great Recession. And yet they obviously believe that monetary policy remains effective at the zero lower bound.

I like praise as much as the next guy, but I would need a Trump-sized ego not to see a great deal of hyperbole in these headlines. More prominent economists like Michael Woodford played a much bigger role in convincing the Fed to up its game. But I’m happy if I had even a small role in changing the zeitgeist.

On the other hand, it is no exaggeration to say that the Fed did “save the economy” from the effect of the fiscal cliff. Indeed, this monetary policy initiative actually produced an acceleration in growth during 2013. A few pundits missed this fact, because they looked at year-over-year annual GDP data, where a weak economy in late 2012 reduced the level of GDP in 2013. But for an austerity package began on January 1, 2013, you need to compare quarterly GDP growth during 2013 to GDP growth during 2012. This measure of growth did accelerate, despite the budget deficit being suddenly slashed from $1061 billion to $561 billion, and despite 350 Keynesian economists issuing this warning:

At the end of the year, we face a congressionally-created “fiscal cliff,” with automatic “sequestration” spending cuts everyone agrees should be stopped to prevent a double-dip recession.

Here’s what Paul Krugman wrote in early 2013, before it became apparent that growth was accelerating:

On the right are the market monetarists like Scott Sumner and David Beckworth, who insist that the Fed could solve the slump if it wanted to, and that fiscal policy is irrelevant. . . .

But as Mike Konczal points out, we are in effect getting a test of the market monetarist view right now, with the Fed having adopted more expansionary policies even as fiscal policy tightens.

And the results aren’t looking good for the monetarists: despite the Fed’s fairly dramatic changes in both policy and policy announcements, austerity seems to be taking its toll.

Contrary to what many people assume, I’m not a Keynesian demand-sider. Nor am I a RBC supply-sider. I’m a supply and demand-sider. Thus I consistently argued that counterproductive labor market policies such as 99-week unemployment benefits were holding back the economic recovery, just as Roosevelt’s NIRA wage policies slowed the recovery during the 1930s.

The extended unemployment benefits ended at the beginning of 2014, reverting to a maximum of 26 weeks. Once again, Keynesians made bad predictions based on a bad model of the economy. They claimed that the end of extended UI benefits would reduce aggregate demand and slow the recovery. Instead, job creation increased sharply in 2014, just as we supply and demand-siders predicted. Payroll employment growth was 2.2 million in 2012, rose to 2.3 million in 2013, and then soared to 3.0 million in 2014.

I’m not pushing the “Fed caused the Great Recession” line to be an obnoxious jerk. I both like and respect Ben Bernanke and appreciate how he tried to twist the arms of Fed hawks to move monetary policy in the correct direction in the 2010s. Nor am I trying to dump on Paul Krugman, who wrote the most important monetary policy paper of the past thirty years. Krugman’s contribution is under-appreciated even by his own fellow Keynesians.

So why not just say, “The Fed should have done more”, a claim that many would agree with, and indeed a proposition endorsed by Ben Bernanke in his post-Fed memoir? Why be so provocative?

My goal here is to move thinking about monetary policy from the widespread impression that it consists of a series of gestures that might or might not “fix problems” to a perception that it’s more like a captain steering an ocean liner.

Bus drivers don’t fix steering problems, they try to avoid creating problems by driving sensibly. I believe it would be very helpful if the Fed were to stop thinking in terms of fixing problems, and instead focus on refraining from creating problems. I’d like to see central banks take ownership over the value of money, and by implication the broader nominal aggregates, because their monopoly on base money gives them a responsibility that they cannot dodge.

I blame central banks for nominal instability because I am trying to instill a “whatever it takes” mentality. Do as much monetary stimulus or contraction as required to maintain NGDP expectations along a 4% growth path. If the phrase “whatever it takes” rings a bell, it is because Mario Draghi made it famous during the Eurozone crisis. He didn’t do as much as I would have liked, but his commitment to whatever it takes was a vast improvement over the dismal record of his predecessor.

More broadly, I hope to develop a framework for thinking about macro issues that is useful. If people don’t agree with me, that’s fine. But I’ve met numerous people that work in the financial industry who have told me that they found my observations to be useful, more useful than the conventional wisdom in the financial press. As long as I continue getting that sort of feedback, I’ll keep calling things as I see them, no matter how much my counterintuitive claims annoy mainstream pundits.

In my first 15 years of blogging at TheMoneyIllusion, I produced roughly 10,000 single spaced Word pages of arguments. Many new readers here are naturally not aware of those posts. I hope you understand that I cannot fit all the arguments from a 400-page book into a single blog post. If there’s enough here to intrigue you, please feel free to check out my book.

PS. My previous “J’accuse” post from 16 years ago has much more detail.

PS. Off topic, but for 10 years I’ve been warning that the US is becoming a banana republic. After yesterday’s sad spectacle, does anyone still question that claim? Yes, the proposed budget is an abomination—the worst in US history.

After years of being out of power, the GOP returns with almost no ideas for supply-side reforms. This is what happens when you expel all of the intellectuals from your party.