Bryan Caplan  

What I Learned From the Crisis

Monetary Policy: Giving and Bu... Heilbroner on Forced Labor...
At yesterday's lunch, Tyler asked us to name the most important lesson we learned from the crisis of 2008.  My answer: The Fed is much worse than I thought.  I used to think we could trust an economist of Bernanke's caliber to deliver tolerably good macro performance using inflation targeting - and avoid giving barbarous politicians the excuse to push bailouts and "fiscal stimulus."  Instead he threw his own principles to the wind, joined the sky-is-falling chorus, and helped end the Great Moderation.

In all fairness, you might object, "Didn't you always hate the Fed?"  But in all honesty, my answer is No.  Yes, the Austrians - especially Rothbard - taught me to loathe the Fed in my late teens, and blame it for all macroeconomic evils.  By grad school, however, I came to see the flaws in the Austrian theory of the business cycle.  And while grad school taught me about mainstream and public choice critiques of central banking, it also persuaded me to consider the possibility that the Fed turned over a new leaf after the 1970s.

At first, the evidence was modest: By 1995, the U.S. had enjoyed a decade of historically low inflation, low inflation volatility, stable output, and tolerable unemployment.  Maybe just a fluke, right?  But the good times kept rolling.  By 2005, I looked back and saw two decades of increasingly impressive results. 

My first-hand acquaintance with high-ranking Fed officials like my teacher Ben Bernanke lulled me further into a false sense of security.  I spent a semester in the front row of his class, and while he was no libertarian, he struck me as a reasonable, thoughtful, decent, market-oriented economist.  With guys like him running the Fed, I figured, nothing outrageous is going to happen.

Normatively, I still favored the privatization of money.  (See here, here, and here).  But the Fed's performance seemed so close to optimal that I lost interest in the topic.  In a world with monstrously harmful and unjust policies like immigration restrictions, 2% inflation didn't seem worth worrying about.

Then came 2008.  As Sumner keeps telling us, all of Bernanke's research prescribed a simple solution: Maintain nominal GDP, and let the other chips fall where they may.  This might have meant quantitative easing instead of targeting short-term interest rates, but that's it.  Instead Bernanke became a key accomplice for the disgraceful series of bailouts, fiscal stimulus, and obfuscation about the zero nominal bound.  The latest round of quantitative easing makes Bernanke's doublethink plain; if he thinks it's going to work in 2010, why wouldn't it have worked in 2008?  And if it would have worked in 2008, why did he join Paulson and Bush's stampede?

In the end, Bernanke's behavior baffles me.  He abandoned his own intellectual positions without explanation, humiliated himself, sparked a terrible recession, set a long list of dangerous precedents, and pushed the U.S. and the world down the road to serfdom.  My best guess is that he simply didn't have the backbone to tell people like Paulson and Bush that they didn't know what they were talking about.  Whatever the reason, though, the crisis forced me to rethink my optimism about the Fed.  Bernanke and company ignored their own research, got predictably bad results, and pleaded impotence.  Instead of playing the voice of reason, they acted like they'd believed in bailouts and fiscal stimulus all along.  I expected better.  I was wrong.

I still think that technocratic economists select better monetary policies than elected politicians would.  But after 2008, that's not saying much.

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COMMENTS (34 to date)
JLA writes:

Bernanke did try quantitative easing in 2008.

Why did he join Paulson and Bush's stampede?

I have no idea. But it's at least possible that Paulson and Bush had suggested far worse policies (say, bank nationalization) and Bernanke persuaded them to take a relatively more market friendly approach.

Doc Merlin writes:

Iirc he did QE in 2008, nothing happened.

Doc Merlin writes:

Yes, this is after all the SECOND round of QE after the first had no effect.

John Thacker writes:

I'm rather astonished that both of you seem to think that the ideas came from Bush. I would think it was clear that Bush was following what advisers and economists were telling him, rather than the other way around (and that this was obvious even before his book came out.)

I am reminded of a story about the steel tariffs, where a junior economic adviser made an offhand comment about "well, we all know that the excuses for the steel tariffs about letting the industry restructure are bogus, but it's a political play to win support for other free trade agreements and politics forces us to do something," and everyone nodded along, only for Bush to stop him and get upset that "no one had told him" that the public excuses for the steel tariffs were untrue. It seems that everyone had internalized the idea that it was a grand political bargain with hidden motives without actually making sure that the boss knew that. (Something I've seen in business before.)

Blaming Paulson makes sense, sure, and there are others (Geithner?) who may have had a role.

But I think it's much more likely that Bush was simply told by economic advisers like Paulson that "if you don't do this, there will be another Great Depression" (and many of the New York banking-centric advisers sincerely believed this), and he listened to his advisers.

I don't see much difference in talking about how Bernanke didn't really want to do it than in talking about how Bush didn't really want to do it either (something that he also insists in his book.)

ajb writes:

All those who think Bernanke did QE in 2008 to a degree consistent with his own theories should read Sumner. Lowering nominal interest rates is NOT EQUAL to easing if real rates are going up. Aside from not preserving nominal GDP he also did the utterly uncalled for: he agreed to pay interest on reserves at the very moment he was lowering interest rates, thus partially sterilizing his own monetary easing. Moreover it sent a signal to the banks that they could avoid lending just when more credit was needed. Markets tanked shortly after these moves.

Even using Bernanke's stated claims to keep inflation at 2% he obviously failed to ease enough when the TIPs markets were predicting deflation in late 2008. By any reasonable measure -- Bernanke's, Sumner's, or Milton Friedman's this was NOT easing. More important the FED showed itself less than credible in its commitment to inflation targeting. The markets dropped as expected.

Old Whig writes:

Didn't you answer this in on of your own posts: "The Sumnerian Missonary"?


"My main quibble: I suspect that top-tier liberal economists favored fiscal stimulus because they saw a golden opportunity to push big government, not because they saw a technical problem with monetary policy.  Uncharitable I know, but I see no other way to explain their sudden change of heart."

No, that's too conspiratorial, he just became intimidated and caved in.

Wonsil writes:

I think you'll appreciate this Bryan:

Quantitative Easing Explained -

This YouTube video contains some language not safe for some workplaces.

liberty writes:

I think what you failed to take account of during your optimistic period is the massive amount of money that can be made during any kind of crisis if certain policies (monetary and fiscal) are taken.

Even if Bernanke was omniscient, and powerful enough to put the best possible policy into place, he alone cannot decide what policy should be taken, and there are people with much more to gain from other policies. Just consider the pockets lined by the bailouts, alone. This is basic common sense - no conspiracy theories and no public choice economics required.

Bill Woolsey writes:

Exactly correct Bryan.


While Bernanke did something they called quantitative easing in 2009 and at the time, I said--great, about time.

But in reality is was credit reallocation. They starting paying interest on reserves. They sold off their treasury portfolio. They instead developed a large set of lending programs, many aimed at promoting the recovery of the securitization markets. Banks could go back to making loans and then selling them (which means banks don't need as much capital as they would if they kept the loans on their balance sheets) and then people would buy the asset backed securities instead of holding short T-bills and bank deposits. This would raise the natural interest rate on T-bills so that the low target for the fed funds rate would be expansionary, it would lower the demand for money (bank deposits) and allow for an increase in money expenditures. It was aimed at fixing credit markets so everything would go back to normal rather than accomodating the increase in the demand for money so that money expenditures would be maintained during a period when there would be major reallocations of credit and reallocations of resources with that reallocation of credit.

If it had worked, then the some of the supply side disruption would have been avoided and money expenditures would have been maintained.

The alternative approach--buying government bonds in large enough quantitities so that the quantity of base money rises enough, and the quantity of money rises enough, to offset any decrease in the money multiplier or velocity--would do nothing for the supply side disruptions. That people no longer trusted securitiized assets means that conventional bank deposits and loans need to expand. Borrowers would have to borrow from banks. Banks would have to hold loans. Banks would need capital. More banks may have failed and FDIC would have had to spend money reorganizing them and bailing out their depositors. (Oh, that happened anyway.)

I didn't think Bernanke's approach of rebuidling the house of cards would work. It didn't work.

fundamentalist writes:

As mainstream econ continues to disappoint, Bryan will find himself becoming more and more Austrian and his arguments against the ABCT less compelling.

RPLong writes:

Now that you've revisited your views on the Fed, maybe it's time you also revisited your views on ABCT... ;) In many ways, Keynesianism was a theoretical justification for central banking. I know you're not a Keynesian, and now I know you're not much of a fan of central banking.

So, maybe it's time we all stopped describing macroeconomic events in Keynesian language.

Kalim Kassam writes:

"My first-hand acquaintance with high-ranking Fed officials like my teacher Ben Bernanke lulled me further into a false sense of security. I spent a semester in the front row of his class, and while he was no libertarian, he struck me as a reasonable, thoughtful, decent, market-oriented economist. With guys like him running the Fed, I figured, nothing outrageous is going to happen."

Could it really be--that even Bryan Caplan suffered from "Greenspanism"? Well, at least I can say that self-awareness is a virtue.

Brian Clendinen writes:

I think Bill Woolsey has is right. What I find outrages is the Fed purchase of Mortgage backed securities. To me the Fed purchase of these securities is a bail-out. Correct me if I am wrong but this was a large part of the original QE.

As far as I am concerned, this is no difference in this verses purchasing commodity futures or stocks other than supposedly the purposes was to increase banks reserves so they could loan more which have very little if any of thou type of assets on their books.

However, I think the smoking gun is the fact that by all measurements the banks did not need the cash to loan. There was not a material difference in the reserves they had to loan. It was fear and unknown risk is the reason they put the break’s on. If there was not a shortage of funds, why would the fed need to purchase securities with unknown risk profiles with huge potential losses to tax payers? I don’t buy it, this was a guise to improve the quality of banks balance sheets by moving the risk to the tax payers.

I know we had this discussion a few months ago base on one of Arnolds post. I did not buy the argument of the side which argued this was really no different from government security purchases.

Lee Kelly writes:

fundamentalist and RPLong,

Bryan has praised Sumner repeatedly and states explicitly that "Bernanke's research prescribed a simple solution: Maintain nominal GDP, and let the other chips fall where they may." It seems to me that Bryan is endorsing nominal spending targeting as the least bad monetary policy given a central bank (and elsewhere he reminds us that his first best world includes the "privatization of money").

One could argue that Bryan's views are similar to some fringe Austrians, but the core of the Austrian school (especially its Rothbardian stalwarts) bitterly disagrees with Bryan's prescriptions. Perhaps Bryan will reconsider ABCT, but I do not see any evidence in this post that his views on the matter are changing.

Al Abbott writes:

Provides an illustration of why some things simply should never be accessible in the political arena. Once a thing is politicized the basis for decision making easily looses connection to reality.

RPLong writes:

Lee Kelly -

You're right about Sumner and Caplan. I guess the next step is to explode the NGDP myth like Mises exploded the monetary velocity myth... ;)

Roger Koppl writes:


Robust political economy, fat tails, black swans. Twenty years is not bad, but trends change and black-swan events happen. Pete and Peter are right to talk about robust political economy, and the story you tell is a great illustration of its importance. The lineage of this idea goes back at least as far Hume and his famous maxim that we must suppose all political actors to be knaves. So the basic point is in the tradition from the start, I think.

aaron writes:

I believe he is far more nefarious:

After going as far as he would in his studies of the Great Depression with historical data, he decided to create his own.

Philo writes:

"Bernanke became a key accomplice for the disgraceful series of bailouts, fiscal stimulus, and obfuscation about the zero nominal bound. The latest round of quantitative easing makes Bernanke's doublethink plain; if he thinks it's going to work in 2010, why wouldn't it have worked in 2008? And if it would have worked in 2008, why did he join Paulson and Bush's stampede?" This is admirably succinct. In answer to your question: "My best guess is that he simply didn't have the backbone to tell people like Paulson and Bush that they didn't know what they were talking about." It does seem that the answer will have to appeal to some defect in Bernanke's character, a defect that had gone unnoticed in his career up to 2008.

Adequate performance as Fed Chairman requires not only academic competence of Bernanke's caliber, which is rare enough, but also near-heroic virtue (that even a generally good person may lack). Conclusion: we should replace the Fed with institutions that can function when operated by "men, not angels."

Max writes:

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fundamentalist writes:

Lee, Bryan seems like he is open to changing his views, though he is a little stubborn. It make take decades of ngdp targeting for him to realize that it does no better than inflation targeting or any other targeting mechanism. Sumner seems to think that Friedman didn't know what he was talking about when he warned about long and variable lags. And the mechanical assumptions about the quantity theory are almost humorous. Someday he will understand what Hayek meant when he talked about the fourth phase of monetary theory in which the effect of monetary policy on relative prices will be the guide.

Chad writes:

Heads up: The link for "inflation targeting" is empty.

Julien Couvreur writes:

Given that you are knowledgeable about Austrian economic analysis, I am surprised by your naivete.

"it also persuaded me to consider the possibility that the Fed turned over a new leaf after the 1970s"

"With guys like him running the Fed, I figured, nothing outrageous is going to happen."

Maybe the problem is not the person in charge, but the system and institution itself?

"2% inflation didn't seem worth worrying about."

Outside of the market, there is no way of rationally knowing the real interest rate. It's not Greenspan or Bernanke's fault.

Similarly, without intervention, how fast would price indexes fall? The comparison is not 2% against 0%, but rather 2% against -X%, as prices would normally fall with increased overall productivity.

"My best guess is that he simply didn't have the backbone to tell people ..."

You're too nice.

"I expected better. I was wrong."

It's ok, the next head of the Fed will do better. (sarcasm)

Sorry for being snarky, but you should know better. Hopefully, you won't be fooled again?

Also, I'm surprised that you don't consider misallocation problems, and the bluntness of Fed policy to restore balance in the complex production structure (it's fundamentally impossible).

Julien Couvreur writes:

I forgot to ask: so what did you actually learn from the crisis?

Jacob Oost writes:

You guys all have lunch together? That's so cute! Do you all sleep in a big bed like the seven dwarfs, and snore in unison?

Also, my two big lessons are A) everything Caplan said, I can't believe I was optimistic about Bernanke at first, and B) "regulatory lock-in" (my way of describing how industries like finance become dominated by a small number of massive players because they are protected by the regulations which raise the cost of entry and inhibit market dynamism) was far more forceful than I had first thought. I guess it takes a real financial crisis to test it.

Mike writes:

I remember when you endorsed Bernanke. I thought that odd, but if libertarian Bryan Caplan endorsed him, that meant something.

Since that time, I have concluded that you did not appreciate how power really works on intellectuals. And I am glad to see that you seem to agree with this take on your prior view of Bernanke.

I don't mean to be too critical. We all make mistakes. But this has been one of your biggest. As usual, you are man enough to admit it. Bravo!

Lee Kelly writes:

RPLong and fundamentalist,

Below is a quote from the introduction of Prices and Production, written after the lectures' original publication:

The second effect of this assumption of separate "stages" of production of equal length was that it imposed upon me a somewhat one-sided treatment of the problem of the velocity of circulation of money. It implied more or less than money passed through the successive stages at a constant rate which corresponded to the rate at which goods advanced through the process of production, and in any case excluded considerations of the changes in velocity of circulation or the cash balances held in the different stages. The impossibility of dealing expressly with changes in the velocity of circulation so long as this assumption was maintained served to strengthen the misleading impression that the phenomena I was discussing would be caused only by actual changes in the quality (sic) of money and not by every change in the money stream, which in the real world are probably caused at least as frequently, if not more frequently, by changes in the velocity of circulation than by canges in the actual quantity. It has been put to me that any treatment of monetary problems which neglected in this way the phenomenon of changes in the desire to hold money balances could not possibly say anything worthwhile. While in my opinion this is a somewhat exaggerated view, I should like to emphasize in this connection how small a section of the whole field of monetary theory is actually treated in this book. (my emphasis)
The 'money stream' is Hayek's term for nominal income/spending. So Hayek is quite explicit: the phenomena discussed in these lectures are caused by 'every change' in nominal spending. For the purpose of illustration, Hayek assumes that velocity is constant so that nominal spending can only be disturbed by changes in the money supply. However, he acknowledges that in reality, these changes are caused 'at least as frequently, if not more frequently, by changes in the velocity of circulation'.

I believe this quote strongly supports interpreting Hayek's work through the lens of monetary equilibrium theory. On the next page, Hayek also claims that 'it is the work of Professor Mises much more than that of Knut Wicksell which provides the framework' for his arguments, and he indicates no disagreement with Mises regarding changes in the 'money stream'. I believe that Hayek's 'fourth stage' of monetary theory, while emphasising the effects of changing relative prices on the structure of production, has a great deal more in common with the views expressed by Caplan and Sumner than many self-identified Austrians.

JA writes:

If someone suggested that we need price controls on say, apples, economists would be aghast because everybody knows what happens when price controls are placed on any commodity or service or rents or anything. Misallocation of resources, shortages, and shoddy products and services. The economy of the Soviet Union or present day Cuba are prime examples of the effects of price controls.
Yet, when price controls are placed on money and controls placed on its supply,we hear of no discussion whatsoever of the stupidity of this; just disagreements as to its extent or duration or whatever. We never read any discussion whatsoever that perhaps some of the fundamental premises of economics are simply wrong. When the results of FED policy do not provide the expected outcome, the rationalizations for the failure pop out of the woodwork, but never questioned is the pseudo-religious belief in economic dogma, esp. that of Keynes.
Modern day mathematical economics has become a study of economic mathematics with elegant proofs that cannot be subjected to controlled experiments; it has become a cult for many in that if their god, JM Keynes said so, well, then, it has to be true; irrespective of whether anything he postulated has ever been shown to work. The total and complete inability of economists to predict anything, even an event that unfolds just a few months later, is proof positive that modern economics is simply a farce, a charade, a mathematical exercise to describe a theoretical utopia non-existent on this planet.
Economics has failed miserably this time around, just as it did in the 1930s and many times since. Economics is junk science, a cargo cult science, an exercise in high powered mathematical fiction. It's about time economists face the truth.

SMIA writes:

The reason that QE hasn't worked (in the sense of stimulating demand) is that, on 10/6/08, the Fed began paying interest on reserves (IOR) for the first time in its 95-year history.

Bank reserves are now equivalent to 1-day T-bills that only banks that are members of the Fed can buy. These 1-day T-bills pay 0.25% interest, which is *far* above the Treasury yield curve. Accordingly, as soon as new money is created, it just goes into bank reserves and sits.

It makes no sense for the Fed to do QE and IOR at the same time. The economy will not recover until the Fed stops paying IOR.

Elder writes:

I think many of the commentators are discounting the fear and uncertainty during the Fall of 2008. Would Greenspan or Volcker have handled it better? It's easy to second guess, but real analysis should go into what should have been done during each phase of the panic.

Aaron writes:

"I still think that technocratic economists select better monetary policies than elected politicians would."

As an Austrian sympathizer, I don't want technocrats or politicians arbitrarily selecting monetary policy. All each of them know are little more than prices controls.

I think the best route would be democratic capitalism in which the market chooses interest rates and solely furnishes a medium of exchange.

jean writes:

I think you misunderstood B.Caplan's post. B.Caplan does in fact think that the Fed should do or should have done *MORE* quantitative easing.

Patri Friedman writes:

Your post mainly focuses on character, which I think is a serious mistake and why you are baffled. When there is a trillion dollars of concentrated benefits on the line, there are many forms of pressure which creative people can bring to bear to advance their interests. Bernanke was surely subject to extraordinary pressures and threats - financial, reputational, and perhaps even physical.

For example, perhaps he was told that if he didn't support bailouts, he would be replaced with someone who did, and he justified his behavior by thinking that he would do them slightly less badly.

I see nothing baffling about people with that much money on the line finding ways to get Bernanke to do the wrong thing. I would find the opposite to be extraordinarily baffling - how could one person stand up to so many people with so much money on the line, and not get shot or threatened or blackmailed or bribed?

Tom Grey writes:

The key problem is that nobody, not one, really knows, what "the right thing" is to do.

What is clear is that a large number of Big Banks would have gone bankrupt; in other words, they would fail to fulfill their contractual obligations.

I think that letting them all follow Lehman would have been far better than another LTCM bailout, but there's no proof. Buffet and most other billionaires "who know better" disagree -- but would have been losing had the market and gov't controlled bankruptcy been followed.

The role of gov't is to handle the situations when peaceful contracts fail, and to attempt to most justly enforce contracts that can no longer be fully enforced. Fast, furious, forced debt-to-equity bankruptcies, wiping out shareholders, CEOs (and all bonuses), perhaps 20% - 50% of the staff (or more?) of the bankrupt banks ... that's what Paulson & Bush should have been pushing.

Perhaps with the Fed ready to loan money to any company needing it (to Main Street), and FDIC already prepared to compensate depositors. The economy didn't need the Big Bank bailout (tho the rich did).

This market solution would have hugely reduced the "income inequality", as well, and thus reduced the demand for more tax based redistribution.

Bryan, do you advocate bailouts and QE I+II in 2008? Or what?

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