US vs. Canadian Monetary Policy During the Boom

James MacGee has an interesting article that compares the post-housing boom period in Canada with that of the United States (hat tip James Hamilton). Specifically, he notes that the housing bust that took place in the United States did not occur in Canada and attempts to explain this difference by looking at the two most common reasons given for the housing boom: (1) loose monetary policy and (2) relaxed lending standards. Looking at both factors, MacGee makes the following observations:

The similarity of the impact of monetary policy and the absence of a housing market bust in Canada suggest that some other factor must have been present in the U.S. to generate the boom and bust. This is not to suggest that “loose” monetary policy did not put upward pressure on housing prices—indeed, both Canada and the U.S. experienced substantial levels of house price appreciation. However, the Canada-U.S comparison suggests that some other factor drove both the more rapid house appreciation and set the groundwork for a U.S. housing bust.

MacGee's claim that monetary policy in the two countries were similar is based on the fact that both policy interest rates followed similar paths during the housing boom (see his central bank target rate figure). Since these indicators of monetary policy did not differ much, he concludes it must be the case that the distinguishing factor between the two countries were the lax lending standards in the United States. I certainly agree that the monetary policy was not the only factor in the housing boom. I hesitate, however, to conclude that because the policy interest rates followed similar paths the stances of monetary policy were also similar. As Nick Rowe points out its not the level of the policy interest rate but where it is relative to the natural interest rate that determines the stance of monetary policy. Consequently, to make a convincing case that monetary policy was similar in Canada and the United States during this time one needs to show the difference between the natural interest rate and the policy interest rate--called the policy rate gap hereafter--for both countries followed similar paths.

So what does the policy rate gap show? It is not easy to answer this question because it requires an estimate of the natural rate of interest for both countries. I am only aware of natural interest rate estimates for the United States covering the housing boom period. Therefore, let me approximate the idea of a natural rate of interest--and will latter corroborate this approach--by looking at the growth rate of labor productivity in both countries relative to the policy interest rate. The natural interest rate, after all, is a function of individuals' time preferences, productivity, and the population growth rate. Of these three components, the one that seems to have changed the most during the housing boom in the United States was productivity. Below is a figure showing the quarterly year-on-year growth rate of labor productivity minus the ex-post real policy interest rate for both countries. (The policy rate in Canada is the overnight rate and in the United States it is the federal funds rate. The ex-post real federal funds rate is used to make a consistent comparison since I could not find quarterly inflation forecasts for Canada.) A positive gap indicates accommodative monetary policy while a negative gaps indicates tightness. (Click on the figure to enlarge it.)



This figure reveals a large policy rate gap for the United States while for Canada it shows one hovering around zero. The figure indicates, then, that monetary policy was not the same in both countries. The Canadian monetary authorities got it about right while the Fed was too accommodating. Now in case you are not convinced that this measure is truly approximating the difference between the natural interest rate and the ex-ante real policy interest rate I have constructed the actual policy rate gap measure for the United States as a comparison. The natural interest rate data comes from this paper by Fed economists John C. Williams and Thomas Laubach while the ex-ante real federal funds rate is constructed by subtracting from the federal funds rate the inflation forecasts from the Philadelphia Fed's Survey of Professional Forecasters. The figure below graphs the two U.S. policy rate gap measures:



The similarity of these two series indicates the productivity-based approximation of the policy rate gap does a decent job. The low interest rates in the United States, then, appear to have been more distortionary than those in Canada.

So what is the take away from this analysis? For starters, monetary policy was an important part of the U.S. housing boom-bust cycle. Moreover, it is possible that the relaxed lending standards themselves cannot be entirely separated from this loose monetary policy. Over at Econbrowser commentator David Pearson sums it up nicely:

Weak underwriting standards and the "Greenspan Put" were joined at the hips. What you call weak underwriting was actually just collateral-based lending (hence no-doc loans basically eliminated ability to pay as a criterion, and zero-down loans depended entirely on the creation of equity value through appreciation). Where did the confidence come from to adopt widespread collateral-based lending? I believe a great deal of it came from the Fed's asymmetric monetary policy. Remember, the underwriting standards were ultimately set by the volume of demand (from hedge funds and the like) for higher-yielding securitizations, and, in turn, that demand was generated by ultra-low interest rates at the short end...

I would also note that during the housing boom interest rates charged to non-conventional mortgages were closely tied to the federal funds rate as seen in the figure below (see this post for more on this point.)

Source: FHFA

Of course, none of this is new. John Taylor already showed us via his Taylor Rule that those countries that deviated the most from the Taylor Rule's tended to have the greatest housing booms.

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Monetary Policy and the Pre-Crisis Problems in Financial Institutions

Many observers have made the case that monetary policy was too loose in the early-to-mid 2000s and, as a result, helped fuel the credit and housing boom. Some observers, however, see little role for loose monetary policy in explaining the distortions that arose in the financial system. For example, Arnold Kling's impressive paper on policies that contributed to the financial crisis finds little importance for monetary policy with regard to the bad bets and excessive leverage taken on by financial institutions during this time. While there are a number of factors that contributed to these developments in the financial system, I want to push back on the notion that monetary policy's role was relatively unimportant. There are at least two reasons why monetary policy was important here: (1) it helped create macroeconomic complacency and (2) it created distortions in the financial system via the risk-taking channel. Let's consider each one in turn.

I. Macroeconomic Complacency
The first point is related to the reduction of macroeconomic volatility beginning in the early 1980s that has become known as the Great Moderation. This development can be seen in the figure below which shows the rolling 10-year average real GDP growth rate along with one-standard deviation bands. These standard deviation bands provide a sense of how much variation or volatility there has been around the 10-year average real GDP growth rate. The figure shows a marked decline in the real GDP volatility beginning around 1983.

Solid line = 10 year rolling average of real GDP growth rate
Dashed line = 1 standard deviation

Now there are many stories for this reduction in macroeconomic volatility and one of the more popular views is that the Federal Reserve (Fed) did a better job running countercyclical monetary policy. In fact, Fed Chairman Ben Bernanke made this very point in a famous 2004 speech. I think there is merit to this view, but not quite in the same way as does Bernanke. During this time one of the key ways through which the Fed was able to reduce macroeconomic volatility was by responding asymmetrically to swings in asset prices. Asset prices were allowed to soar to dizzying heights but cushioned on the way down with an easing of monetary policy (e.g. 1987 stock market crash, 1998 emerging market crisis, 2001 stock market crash). The Fed also used its powerful moral suasion ability to goad creditors into helping the distressed and systemically important LTCM hedge fund. All of these actions served to prevent problems in the financial system from affecting the real economy and thus, were probably a big factor behind the "Great Moderation" in macroeconomic activity. However, they also appear to have caused observers to underestimate aggregate risk and become complacent. This, in turn, likely contributed to the increased appetite for the debt during this time. This interpretation of events was recently alluded to by Fed Vice-Chairman Donald Kohn in a 2007 speech:

In a broader sense, perhaps the underlying cause of the current crisis was complacency. With the onset of the “Great Moderation” back in the mid-1980s, households and firms in the United States and elsewhere have enjoyed a long period of reduced output volatility and low and stable inflation. These calm conditions may have led many private agents to become less prudent and to underestimate the risks associated with their actions.While we cannot be sure about the ultimate sources of the moderation, many observers believe better monetary policy here and abroad was one factor; if so, central banks may have accidentally contributed to the current crisis.

So a macroeconomic complacency created in part by the Federal Reserve set the stage for one of the biggest credit and housing booms in modern history.

II. The Risk-Taking Channel of Monetary Policy
The risk-taking channel of monetary policy is one that looks at the relationship between the Fed's interest rate policy and risk-taking by banks. Leonardo Gambacorta of the BIS summarizes how this link works:

Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.

He goes on to empirically show a strong link between the easy monetary policy and risk-taking by banks during the early-to-mid 2000s using a database of 600 banks in the Europe and the United States. Similar work has been done by Tobias Adrian and Hyun Song Shin as I noted in this previous post. In their paper they find the following:

We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets.

I see the macroeconomic complacency idea discussed above as setting the stage for and reinforcing the risk-taking channel of monetary policy. Of course, if so then this undermines the the Sumnerian view that all was well with a 5% trend growth rate for nominal expenditures during the Great Moderation but that is another story.

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The Stance of Monetary Policy Via the "Risk-Taking Channel"

There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of the challenge in measuring the stance of monetary policy is that there are multiple transmission channels through which monetary policy can work: the interest rate channel, the balance sheet channel, the bank lending channel, the wealth effect channel, unanticipated price level channel, the exchange rate channel, and the monetarist channel. (See here and here for a discussion of these channels.) Knowing the true stance of monetary policy depends in part on knowing which monetary transmission channels are most important at a given time.

Tobias Adrian and Hyun Song Shin make the case that one of more important channels in recent years is one that really hasn't been considered yet: the risk-taking channel. This channel measures the stance of monetary policy by looking at balance sheet quantities of financial intermediates:

We reconsider the role of financial intermediaries in monetary economics. We explore the hypothesis that financial intermediaries drive the business cycle by way of their role in determining the price of risk. In this framework, balance sheet quantities emerge as a key indicator of risk appetite and hence of the “risk-taking channel” of monetary policy. We document evidence that the balance sheets of financial intermediaries reflect the transmission of monetary policy through capital market conditions. We find short-term interest rates to be important in influencing the size of financial intermediary balance sheets. Our findings suggest that the traditional focus on the money stock for the conduct of monetary policy may have more modern counterparts, and we suggest the importance of tracking balance sheet quantities for the conduct of monetary policy.

While this channel works through balance sheet quantities of financial intermediates, it is important to note that changes in the federal funds rate are important in influencing the size of the balance sheets. This, then, provides another reason why the Fed's low interest rate policy in the early-to-mid 2000s was highly distortionary. The WSJ recently ran a story that highlighted Adrian and Shinn's work. Here are some key excerpts:

Fed officials are now debating the differences between bubbles as a way to understand them better and come up with the right solutions. Two economists influencing the debate are Tobias Adrian, a New York Fed researcher, and Hyun Shin, a Princeton professor. Their work shows that the credit bust was preceded by an explosion of short-term borrowing by U.S. securities dealers such as Lehman Brothers and Bear Stearns.

For instance, borrowing in the so-called repo market, where Wall Street firms put up securities as collateral for short-term loans, more than tripled to $1.6 trillion in 2008 from $500 billion in 2002. As the value of the securities rose, so did the value of the collateral and the firms' own net worth. That spurred firms to borrow even more in a self-feeding loop. When the value of the securities started to fall, the loop went into reverse and the economy tanked.

The lesson: The most dangerous part of a bubble may not be the rise in asset prices, but the level of debt that builds up at financial institutions in the process, fueling even higher prices. That means keeping these debt levels down might be one way to prevent busts.

Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."[emphasis added]

His co-author, Mr. Shin, says "clumsy financial regulations" aren't enough to stop boom-bust cycles. "This would be like trying to erect a barrier against the incoming tide using wooden planks with big holes," he says. Using interest rates is the "most effective instrument" for regulating risk-taking by firms, he says in a new paper.

No one at the Fed has yet come out in favor of raising interest rates to stop the next bubble, but the idea is being discussed more seriously among Fed officials. Mr. Bernanke has been following Mr. Adrian's work closely.

I find this very encouraging. Apparently, Ben Bernanke is taking this risk-taking channel seriously along with its implications: the low federal funds rates in the early-to-mid 2000s was a mistake. Maybe we won't repeat the same mistakes after all.

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Greenspan's Cult of Personality

Alan Greenspan was a legend in his time and there was no shortage of praise for him back then. For example, who can forget Bob Woodow's 2000 book Maestro: Greenspan's Fed and the American Boom. While I was aware of this Greenspan devotion, I never realized the extent to which it rose until I read David Wessel's In Fed We Trust. In the chapter title "The Age of Delusion", Wessel directs us to a paper delivered at a major economic symposium in 2005 that had this passage in the introduction:

No one has yet credited Alan Greenspan with the fall of the Soviet Union or the rise of the Boston Red Sox, although this may come in time as the legend grows. But within the domain of monetary policy, Greenspan has been central to just about everything that has transpired in the practical world since 1987 and to some of the major developments in the academic world as well. This paper seeks to summarize and, more important, to evaluate the significance of Greenspan's impressive reign as Fed Chairman... There is no doubt that Greenspan has been an amazingly successful chairman of the Federal Reserve System. (pp. 11-12)

This 86-page paper praising Greenspan's record epitomizes the cult of personality Greenspan had at this time and it is one reason why we got the economic debacle we are in now. Under Greenspan leadership, the Fed asymmetrically responded to swings in asset prices as they were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. While this approach probably contributed to the "Great Moderation" in macroeconomic activity it also appears to have caused observers to underestimate aggregate risk and become complacent. It is likely that it also contributed to the increased appetite for the debt during this time. These developments all helped spawn the current crisis. Greenspan's cult of personality meant little-to-no questioning of his policies.

Now not everyone bowed to emperor Greenspan. There were a few who saw his record differently. Here is one such prominent economist writing also in the year 2005 in the magazine Foreign Policy:

U.S. Federal Reserve Board Chairman Alan Greenspan is credited with simultaneously achieving record-low inflation, spawning the largest economic boom in U.S. history, and saving the world from financial collapse. But, when Greenspan steps down next year, he will leave behind a record foreign deficit and a generation of Americans with little savings and mountains of debt. Has the world's most revered central banker unwittingly set up the global economy for disaster?

Unfortunately, this view was the exception not the rule. Let us never allow another cult of personality to develop within the Federal Reserve.

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More Fed Cheerleading

The battle for the narrative of the Fed actions in the early-to-mid 2000s continues. The latest salvo comes from a blog post by David Altig of the Atlanta Fed and a Cato Policy Analysis piece by Jagadeesh Gokhale and Peter Van Doren. In both cases the authors absolve the Fed of any wronging doing during the housing boom period. I am not surprised to see Fed cheerleading coming from a Fed insider, but from the CATO institute? These are strange times.

In the first article, Altig conveniently finds a modified form of the Taylor Rule that shows the Fed acted no differently than it had in past 20+ years when monetary policy seemingly worked fine. The first problem with this piece is the obvious problem of data-mining a modified Taylor Rule that justifies ex-post his employers actions. If Altig really wants to be convincing, he needs to explain why the original Taylor Rule, which does show the Fed being unusually accommodative during the housing boom, is suspect and why his modified Taylor Rule is better. As John Taylor has shown, the original Taylor rule goes a long way in explaining this crisis. For example, Taylor shows in the figure below that deviations from the Taylor rule in Europe were closely associated with changes in residential investments during the housing boom there (click on figure to enlarge):


Even if Altig could show that his modified Taylor rule makes more sense, there is still the question of whether monetary policy was truly optimal during the previous 20+ years to the housing boom. This was the period of the Great Moderation--a time of reduced macroeconomic volatility--whose appearance has been attributed, in part, to improved monetary policy. As many observers have noted, though, this also was a period of the Fed asymmetrically responding to swings in asset prices. Asset prices were allowed to soar to dizzying heights and always cushioned on the way down with an easing of monetary policy. This behavior by the Fed appears in retrospect to have caused observers to underestimate aggregate risk and become complacent. It also probably contributed to the increased appetite for the debt during this time. To the extent these developments were part of the reason for the decline in macroeconomic volatility, the Great Moderation and the monetary policy behind it becomes less of a success story.

In the second article Gokhale and Van Doren make the following arguments: (1) detecting asset bubbles is a difficult thing to do; (2) even if the Fed could have detected and popped the asset bubble in the housing market in the early-to-mid 2000s it would have done so at the expense of a painful deflation; and (3) the Fed's ability to reign in home prices was limited. On (1) I agree that responding to an asset bubble after it has formed is challenging. But that is not the the point of most observers who find fault with the Fed during this time. They would say the Fed could have prevented the housing boom from emerging in the first place had monetary policy started tightening before June 2004. On (2) the authors still think the deflationary pressures of that time were the result of a weakened economy. This is simply not the case. As I just recently noted on this blog (here and here), rapid productivity gains were the source of the deflationary pressures, not declining aggregate demand. In fact, by 2003 nominal spending was soaring at a rapid pace. In other words, the deflationary pressures of 2003 were vastly different than the deflationary pressures of 2009. On (3) the authors claim that there was simply no way for the Fed to reign in home prices since the influence of its target federal funds rate on other interest rates declined during the time of the housing boom. While it is true the link between monetary policy and long-term interest rates is more tenuous, the authors argue that even interest rates on ARMs and other subprime-type mortgages were beyond the Fed's influence. A CATO Policy Briefing by Lawrence H. White, however, provides evidence that the supbrime market was in fact very sensitive to the Fed's action during this time. Below is figure that corroborates White's work by showing the effective interest rates on ARM mortgages along with the federal funds rate. Is there any doubt? (Click on figure to enlarge):

Update: To support my claim that nominal spending was soaring by 2003 I have posted a figure below that shows the growth rate of domestic demand relative to the federal funds rate since 2002. The years 2003 to 2004 are marked off by the dashed lines. Note that the growth rate of nominal spending is increasing during the 2003-2004 period while interest rates are kept low for most of the period (click on figure to enlarge):

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How Well Known Was the Productivty Surge of the Early 2000s?

In my previous post I noted that the rebound in productivity growth that started in the 1990s did not end with the tech bubble bursting in 2000. Rather, it took a temporary respite and then continued to accelerate for a few more years. The point of my sharing this information is that the robust productivity gains of the early-to-mid 2000s imply interest rates should have been higher. Instead they were dropping, a sign that monetary policy was too loose. This development also sheds light on the origins of the deflation scare of 2003: inflation was falling because of positive aggregate supply shocks (i.e. the rapid productivity gains) not negative aggregate demand shocks as was believed back then. Nominal spending, in fact, was soaring during this period. Consequently, the U.S. economy was getting juiced-up on easy money at same time it was being buffeted with positive productivity shocks. This policy response primed the U.S. economy for the emergence of economic imbalances.

A few commentators objected to this interpretation of events. They conceded that the actual productivity growth rate may have continued to surge, but questioned whether productivity expectations kept up with reality. Instead, they surmised that expectations of productivity growth declined after the tech bubble burst. If so, the expected marginal product of capital would have declined, investment demand would have decreased, and the neutral rate of interest also would have fallen. This is a great objection and one I had to check out. First, I went to the Survey of Economic Forecasters from the Philadelphia Fed and looked at the forecast of the average productivity growth rate over the next 10 years. This series begins in 1992 and is graphed below (click on figure to enlarge):


This figure show that the 10-year productivity forecast decline slightly in 2002 but resumed its climb in 2003. It peaks out in 2004, with mild declines in 2005 and 2006. By 2007 the writing was on the wall and the forecast begins to rapidly decline. This figure suggest, then, the actual productivity gains during this time were known and shaping the long-term forecast of productivity growth.

As a robustness check--and because I vaguely remembered there being a lot productivity stories in the media back in 2003-2004--I went to Lexus-Nexus and did a U.S. newspaper and news wire search with the following key words: productivity growth, accelerated or increased or pick up or faster or miracle or upward or improved or strong or robust or sustained. This search was intended to pick up articles, if any, discussing the productivity surge at the time. Here is what I found over 1992-2009 (click on figure to enlarge):

This figure shows a similar pattern: news stories on positive productivity growth articles temporarily declined in 2001 but then continued their upward momentum thereafter. The series peaks in 2005 and then begins a dramatic collapse. The positive productivity news stories bubble pops at that time.

The above figures may not convince everyone, but they are enough evidence for me to conclude that my earlier interpretation of events during the early-to-mid 2000s cannot be too far off the mark.

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One-Size-Fits-All Monetary Policy Does Not Work

Many times I have discussed here how the Eurozone is far from an optimal currency area--its member countries have different business cycles and insufficient economic shock absorbers in place--and the problems that this reality creates for the ECB in conducting monetary policy.  One of the key problems is that the ECB is applying a-one-size-fits-all monetary policy to vastly different economies.  For example, consider the case of Ireland and Germany.  When the Euro was adopted in 1999 Ireland was growing close to 10% while Germany was growing around 3%.  Should the ECB be responding to Ireland, Germany, or the average in setting its target interest  rates?  As the figure below shows, up through the end of the housing boom period Ireland was consistently growing faster than Germany. (Click on figure to enlarge.) 

Via Ralph Atkins we learn of Barclays Capital report that looks closely at this issue. Unsurprisingly, it finds the following:

ECB interest rates have generally corresponded more to economic conditions in Germany - the eurozone’s biggest economy - than the eurozone as a whole.

This means ECB monetary policy was well-suited for the low-growth German economy, but way too easy for the hot Irish economy.  Easy monetary policy, therefore, must have been an important contributor to the housing boom in Ireland during this time. I think Josh Hendrickson would agree.

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Critically Assessing Bernanke's Record

Now that Bernanke has been renominated to lead U.S. monetary policy his time at the Fed is being critically assessed by a number of observers. Here are five assessments:

(1) Simon Johnson says there are multiple versions of Bernanke--the one that saved the financial system after the Lehman-AIG collapse, the one that intellectually justified Greenspan's low interest rate policy and indifference to asset bubbles, and the one that has pushed for reform of the financial system--and would like to know which one we are going to get in his second term. He also is resigned to the fact that the current Fed policies will most likely lead to another bubble and financial crash.

(2) Stephen Roach highlights three critical mistakes Bernanke made: (i) he saw no need for the Fed to preempt asset bubbles, (ii) he was the intellectual architect of the saving glut view that allowed the Fed to turn the other way when housing boom was taking off, and (iii) he failed to take seriously the need to get a handle on the seriousness of the derivative explosion, the shadow banking system, and the extent of leverage in the U.S. economy.

(3) Ambrose Evans-Pritchard notes that it was Bernanke who provided "academic cover" for (i) Greenspan's view that asset bubbles do not matter and for (ii) holding down interest rates for so long below their neutral level.

(4) Desmond Lachman believes Bernanke's heroic efforts over the past nine months must not overshadow the indifference Bernanke's Fed had toward the housing boom in 2006 and 2007 leading up to the crisis nor his role in the Lehman debacle.

(5) Barry Ritholtz acknowledges that Bernanke's endorsement of Greenspan's interest rate policies were problematic and that his views on asset bubbles and the saving glut gave credence to the Fed's indifference to the housing boom. However, Ritholtz ultimately holds Greenspan accountable for the policies of that time.

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Fed Smackdown Edition

My critiques of Fed policies in the early-to-mid 2000s are beginning to look tame compared to these observers. First, here is a Free Exchange summary of a Lutz Kilian paper:

[E]xcessively accommodative monetary policy and regulatory policy over the last decade may have led to unsustainably high global growth, which in turn was responsible for a demand driven spike in oil prices. There are two angles to this. One is that the natural unemployment rate was higher than the Fed thought, and the only way to push unemployment below that level was to facilitate bubbles in the financial and housing sectors, which excessively juiced demand and enabled the oil spike. The other is that lax monetary policy kept American consumption at too-high levels, leading to very rapid emerging market growth (which was exacerbated by the fact that dollar pegs led to importation of loose American monetary policy in trading partner economies).

Boiling this down, Mr Kilian seems to be suggesting that a monetary policymaker with this reading of the economy would have acted more cautiously than someone with Ben Bernanke's view ("that the oil price shocks of the 1970s and 1980s arose exogenously with respect to global macroeconomic conditions"), potentially reducing the magnitude and impact of the 2007-2008 oil shock.

Next up is Daniel Gross, Jacopo Carmassi, and Stefano Micossi. They write in this Vox article that too many observers confuse the symptoms of the economic imbalances as causes. For example, they note the following:

A key feature of a speculative bubble is the attendant anomalous convergence of expectations that occurs when a growing share of investors believes that prices can only go up and that the risk of reversal somehow disappears... Shiller believes that convergence of expectations is a natural, endogenous phenomenon engendered by such things as a long-established benevolent economic environment and economic innovations announcing a new era of prosperity...

However, a straightforward alternative is that monetary policy itself provided the anchor for the convergence of expectations, based on the consistent record that any decline in asset prices would be countered by the Federal Reserve with vigorous monetary expansion. Indeed, Alan Greenspan had just arrived at the Federal Reserve at the time of the 1987 stock market crash; he promptly reacted by aggressively lowering policy interest rates. He did it again in 1998 at the time of the LTCM crisis that followed the East Asian and Russian crisis, and even more aggressively after the end of the dot.com bubble in 2000. In all these episodes, there were no adverse effects of falling asset prices on economic activity and subsequently stock prices recovered.

The pattern is clear – the Fed repeatedly and systematically intervened to counter “negative bubbles”, while it remained passive when confronted with accelerating credit and asset prices. This policy approach, long established and clearly announced for over a decade, must have played an important role in bringing about convergent expectations of ever-rising asset prices, which eventually destabilised financial markets and the economy. Such an asymmetric monetary policy creates a gigantic moral hazard problem, whereby all agents expect to be rescued from their mistakes.

They conclude,

... the massive financial instability of 2007-8 was primarily the result of lax monetary policy, mainly in the US. The regulatory system compounded this error by tolerating excessive leverage and maturity transformation by banks in the US and Europe. Innovation did contribute to credit expansion and instability, but in all likelihood, without lax money and excessive leverage, reckless bets on asset price increases would have been much reduced.

Finally, Simon Johnson calls on the Fed for an apology for its failure to even consider financial sector issues in its 2003 FOMC meetings:

[T]his and other FOMC transcripts make it clear that the senior Fed decision makers [in 2003] were not even thinking about the first order financial sector issues. They weren’t aware of what the big investment banks were really doing – show me the intelligence reports before the FOMC or the analytical discussion that indicated any degree of worry. No doubt someone somewhere in the Federal Reserve system was thinking critically about finance – feel free to send me any relevant details - but from the point of view of evaluating the institution, it only counts if the top decision-making body at least has the issues on the table.

[...]

I fully understand that financial market considerations are not the established focus of central bank interest rate deliberations. But the scope and nature of such deliberations has changed a great deal since the founding of the Fed almost 100 years ago. As the economy changes, central banks have to adapt their conceptual frameworks and our broader regulatory frameworks need to change also.

Huge problems were missed by people using anachronistic conceptual frameworks. Those frameworks should change... Our top monetary policy makers completely missed the true nature of the Great Bubble and its consequences, until it was far too late. They should apologize for that and we can start work on redesigning the institution, its decision-making, and how financial markets operate, to make sure it won’t happen again.

That is enough Fed smakckdown for one day.

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Martin Wolf's Counterfactual Question

Recently I had an interesting conversation with Martin Wolf of the Financial Times. We were discussing whether it was the Federal Reserve (Fed) or the saving glut from emerging markets that fueled the global liquidity glut in the early-to-mid 2000s. Martin Wolf argued it was the saving glut that was the important enabler and that the Fed's response was more or less an endogenous one. I, however, made the case that the Fed played an important role in creating the global liquidity glut given its monetary superpower status. By the end of the conversation our disagreements had narrowed, but one of the unresolved questions we ended on was whether the Fed could have acted differently given the political economy of the time. Here is Martin Wolf replying to me:

Yes, the Fed could have chosen otherwise, by a mixture of monetary and regulatory policies. I do not disagree. But to have done so would have meant a weaker recovery in domestic output. That might have been the right policy. But could it have got away with it? Who knows?

So what do you think? Could this counterfactual have happened in the 2003-2005 period? As I have noted before, productivity and aggregate demand growth were robust during this time, suggesting tightening could have occurred without harming the recovery. On the other hand, employment growth was sluggish and the political push for increased home ownership would have made tightening politically challenging. Of course, the whole point of having an independent central bank is for moments like these, when tough calls have to be made.

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What if the Federal Reserve Had Listened to the BIS?

What do you get when the key insights of Hyman Minsky--prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the "good times" and underestimate risk going forward--and Frederick Hayek--price stability is not a sufficient condition for macroeconomic stability--are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers. Here is Der Spiegel:

[William] White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative -- and hazardous.

As far back as 2003, White implored central bankers to rethink their strategies... The prevailing model [at central banks] was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.

William White and his crew took this message directly to key players time and time again. Among other publications, they did so with this paper presented at the Fed's Monetary Policy symposium at Jackson Hole Wyoming in August 2003 (Greenspan was in attendance), as well with this paper titled "Is Price Stability Enough" in 2006, and in many of the popular BIS Annual Reports. My favorite article of the bunch is the second one above which happens to have been written by White himself. Here are some excerpts:

It will be argued in this paper...that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”. The historical record indicates that mean reversion is a common outcome, with associated and negative implications for future aggregate demand.

[...]

One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one.

This is the same point I have made here on this blog: by avoiding the benign deflationary pressures of 2003 the Fed help put in motion the developments that created the malign deflationary pressures of 2009. If only the folks at the BIS had been taken more seriously. One can only imagine how different the current economic crisis would have been.

Update: Presto Pundit in the comments points us to an article that chronicles the ongoing debate between William White and Alan Greenspan.

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Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake

Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure below (click on figure to enlarge):


Here we see productivity growth soaring just as the real federal funds rate is being pushed into negative territory. Normally, a rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):


The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here.

The final data issue is the weak employment growth coming out of the 2001 recession. Given the above discussion, the best interpretation of this development is there was less demand for labor in the recovery given the productivity gains. In fact, this was common explanation given at the time. One could also argue that the Fed's low interest rate policy may have pushed some firms to inordinately substitute out of labor to capital.

Here is the bottom line: there is enough evidence for Brad DeLong to conclude that Federal Reserve's low interest rate policy was a mistake.

Update: Brad DeLong responds to this and other posts.

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Understanding Recent Economic History

The Economist magazine has an article on what it sees as the beginning of a new global economic order. In the article, the history of international monetary systems up through the present economic crisis is reviewed. Here is an excerpt from this history that I particularly liked:

The post-Bretton Woods system worked well, engendering the long period of low inflation and steady growth known as the Great Moderation. But one of the reasons for its apparent success—the growth of India and China—may have sparked its demise. The addition of these two great nations to the international financial system was a supply shock that put downward pressure on inflation rates.

As Stephen King, an economist at HSBC, has pointed out, the result might have been a benign deflation that boosted Western living standards. But central banks struggled to avoid a deflationary outcome; the result was a loose monetary policy that encouraged asset bubbles. Those bubbles lasted longer than expected because the flood of savings from developing markets held down the risk-free rate.

This is spot-on analysis by The Economist. I make a similar argument in this recent article in the Cato Journal.

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The First Crack in the Fed's Armor

The WSJ is reporting that former NY Fed President and now U.S. Treasury Secretary Timothy Geithner admitted that the loose monetary policy of the Fed and other central bankers in the early-to-mid 2000s contributed to the economic imbalances that led to this current economic crisis:

I would say there were three types of broad errors of policy and policy both here and around the world. One was that monetary policy around the world was too loose too long. And that created this just huge boom in asset prices, money chasing risk. People trying to get a higher return. That was just overwhelmingly powerful...It was too easy, yes. In some ways less so here in the United States, but it was true globally. Real interest rates were very low for a long period of time.

For all the grief the Treasury Secretary is receiving, he should be given credit for this admission of policy failure. I would note, though, that monetary policy was highly expansionary across the globe primarily because it was expansionary in the United States. As I have noted earlier:

The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

I am hoping the Secretary's admission will open the door for a mea culpa from those Fed officials who actually oversaw U.S. monetary policy at this time. If we are to learn from this experience we need to come clean on all the contributors to this economic crisis.

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The Latest Fed Smackdowns

Here are the latest critiques of Fed policy in the early-to-mid 2000s. First up is Roger Lowenstein:

[A]s it still does today, the Fed continued to concentrate on inflation in consumer goods such as cars and computers while all but ignoring speculation in investment assets.

By focusing so zealously on inflation, the Federal Reserve is essentially fighting the last war. The United States' most recent bout of serious inflation occurred in the 1970s and early '80s; in response, then-Fed Chairman Paul Volcker moved aggressively to raise rates in order to curb prices. Since then, asset bubbles have been inflating and popping ever more often.

Excesses that in the past would have produced inflation now cycle back into the economy through the financial markets.

It sounds like Lowenstein has been reading some of William White's work, maybe even his classic "Is Price Stability Enough?" My own answer to White's question is no, price stability is not enough. As I have said before, the Fed's focus should not be on stabilizing inflation but on stabilizing aggregate demand. Given current institutional arrangements, I would also like to see some form of macroprudential policies implemented as well. After all, the period of the Great Moderation was one with relatively stable aggregate demand growth but still experienced unsustainable expansions of credit and debt.

Next up is Barry Ritholtz. I am not sure what motivated this outburst today at the Big Picture, but I liked it:

I Direct Your Attention, Mr. Fed Chairman, to Exhibits 1 through 10:

1. Ultra low interest rates led to a scramble for yield by fund managers;

2. Not coincidentally, there was a massive push into subprime lending by unregulated NONBANKS who existed solely to sell these mortgages to securitizers;

3. Since they were writing mortgages for resale (and held them only briefly) these non-bank lenders collapsed their lending standards; this allowed them to write many more mortgages;

4. These poorly underwritten loans — essentially junk paper — was sold to Wall Street for securitization in huge numbers.

5. Massive ratings fraud of these securities by Fitch, Moody’s and S&P led to a rating of this junk as TripleAAA.

6. That investment grade rating of junk paper allowed those scrambling bond managers (see #1) to purchase higher yield paper that they would not otherwise have been able to.

7. Increased leverage of investment houses allowed a huge securitization manufacturing process; Some iBanks also purchased this paper in enormous numbers;

8. More leverage took place in the shadow derivatives market. That allowed firms like AIG to write $3 trillion in derivative exposure, much of it in mortgage and credit related areas.

9. Compensation packages in the financial sector were asymmetrical, where employees had huge upside but shareholders (and eventually taxpayers) had huge downside. This (logically) led to increasingly aggressive and risky activity.

10. Once home prices began to fall, all of the above fell apart.

I hate having to repeat myself, but it is apparently, necessary.

Well said Barry!

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Steve Hanke on the Fed's Policies

Steve Hanke makes the case that the Fed's misreading of the deflationary pressures in the early-to-mid 2000s caused it to overreact at the time:

One of our problems is the Fed's preoccupation with the risk of deflation. Fixated on this risk in 2002 and 2003, Greenspan pumped out dollars, cutting the Fed funds rate down to 1%. The easy credit boom continued, inflating asset prices...

What the Fed has failed to realize is that most deflations are good ones, not bad ones. During the last two centuries there have been many deflations throughout the world. Almost all of them have been good ones precipitated by technological innovation, rising productivity, global capital flows and sustained economic growth. If farm mechanization cuts the price of wheat, you get a rising living standard. This is good.

Instead of lowering interest rates seven years ago, the Fed should have raised them. This would have blunted the credit boom that led to the bubble. The most visible excess was a buildup in debt relative to GDP and a deterioration of debt quality. Combined government, corporate and household debt is now 250% of annual GDP, double what it was a generation ago. A lot of the debt on both corporate assets and houses is junk. It can be repaid only by refinancing on the back of ever higher asset prices.

As readers of this blog know, I take a similar view on the deflationary pressures at that time. However, I have also argued there were a number of factors that came together--not just loose monetary policy--to create the perfect financial storm. Still, a good look at the evidence indicates the Fed's approach was highly distortionary at the time.

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Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:

[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

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Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

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Greenspan's Failed Attempt to Exonerate the Fed

Alan Greenspan is again defending U.S. monetary policy under his watch. Writing in the Wall Street Journal last week he acknowledges interest rates were too low in the past decade, but not the short-term interest rate targeted by the Federal Reserve (Fed). Rather, it was those stubborn long-term mortgage rates that failed to go up when the Fed started its tightening cycle in 2004. So do not blame the Fed, blame those folks overseas whose excess savings were funneled into the United States and, in turn, pushed down long-term interest rates. These are the real culprits according to Greenspan.

Greenspan's defense is wrong on several counts.

First, as noted by observers such as Barry Ritholtz and Larry White much of the problematic mortgage lending took place under adjustable rate mortgages, interest-only mortgages, and other non-traditional mortgages whose interest rates were tied to short-term interest rates. Thus, the Fed's super low interest rate policy in the early-to-mid-2000s was highly consequential to these types of loans.

Second, Greenspan's invoking of the interest rate "conundrum"--the Fed pushing up short term rates in the mid-2000s but long-term rates not following--and explaining it away by the foreign saving glut makes it appear that the Fed was helpless at that time. As Greg Ip shows this was not the case. The Fed could have tightened monetary policy or tightened the lending standards in the mortgage industry. While Greg is technically correct, I will go one further and say the saving glut story is at best a partial explanation for the conundrum. Another more compelling story is that there was no conundrum, but rather the bond market was expecting a recession in the near future and pricing it into long-term interest rates. In short, the conundrum was simply the case of a yield curve inverting and pointing to a recession. Moreover, this explanation makes sense in light of the fact that yield curves across the globe were flattening or inverting and thus indicating a global recession was in store. (See here and here for more).

Third, Greenspan overlooks the fact that Fed is a monetary superpower whose loose monetary policy got exported to the rest of the world in the early-to-mid 2000s. As I wrote earlier:

One important factor was the emergence of an unexpected global liquidity glut created by the Federal Reserve (Fed) in the early-to-mid 2000s. The Fed is a is a monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. (See this post on evidence for U.S. monetary policy being exported to ECB.) The global liquidity glut story seems most compelling for the 2002-2004 period when the Fed's policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate). Thus, its highly accommodative monetary policy during this time was exported to the world.

This global liquidity glut served to facilitate a global credit expansion and as a result, a global housing boom. Yes, there was also a saving glut coming out of Asia and oil-exporting countries but it was more important to the story beginning about 2005 after the Fed's tightening cycle had begun to be take hold.

Finally, the original motivation for Greenspan's easing in the early-to-mid 2000s was a case of misreading the deflationary pressures. As documented in this post, nominal spending was not collapsing at the time. Also, the lack of robust employment gains coming out of the 2001 recession were not alarming given the robust productivity growth and the (policy-induced) low interest rates that encourage inordinate substitution of capital for labor.

To be clear, there were other developments such as the the securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agency failures, etc. that contributed to the current economic crisis. The Fed's role in this crisis, though, is unmistakable and clear. Consequently, no matter how many editorials Greenspan writes he will never be able to exonerate the Fed from the responsibility it bears for this crisis.

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A Step in the Right Direction

So it seems likely that Janet Yellen will be the next Vice Chair of the Fed. I believe she is a great choice for several reasons. First, unlike Bernanke and other Fed apologists, she acknowledges U.S. monetary policy may have played a role in the housing boom:

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy. However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Second, as noted above she is open to some form of macroprudential regulation. I have become convinced by Claudio Borio, William White and others at the BIS that this is an important idea given the current realities in the financial system. Third, Yellen acknowledges that the Fed is a monetary superpower. Just admitting this point means she is taking seriously the Fed's role in creating global liquidity conditions. Any candidate who brings such fresh thinking on these three issues to the Board of Governors would be a welcome change in my view. Yes, there are areas where I disagree with her--she thinks monetary policy is limited at the zero bound, I do not--but on balance she brings a perspective to the Fed that if followed makes its less likely the Fed will repeat the monetary policy mistakes it made in the early-to-mid 2000s. Making Janet Yellen the next Vice Chair is a step in the right direction for improving the Fed.

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