Scott Sumner  

Robert Hetzel explains why the real problem was nominal

I Win My Inflation Bet with Ro... NGDP or NGO?...

After I began blogging in early 2009, I started giving talks entitled "The Real Problem Was Nominal." I argued that tight money, not financial distress, was the cause of the Great Recession.

As far as I know, Robert Hetzel was the only Fed insider who understood this at the time, probably even before I did. Here are some excerpts from his Richmond Fed paper, published in the spring of 2009:

The recession intensified in 2008:Q3 (annualized real GDP growth of −.5 percent). That fact suggests that, prior to the significant wealth destruction from the sharp fall in equity markets after mid-September 2008, the real funds rate already exceeded the natural rate. The huge wealth destruction after that date must have further depressed the natural interest rate and made monetary policy even more restrictive. It follows that the fundamental reason for the heightened decline in economic activity in 2008:Q4 and 2009:Q1 was inertia in the decline in the funds rate relative to a decline in the natural rate produced by the continued fall in real income from the housing price and inflation shock reinforced by a dramatic quickening in the fall in equity wealth.

Indeed it was even worse than Hetzel suggested; revised figures show real GDP falling at a 1.9% rate in the third quarter, and an 8.2% rate in Q4. The following footnote, describing a September 2008 report by Macroeconomics Advisers, also points to the key monetary policy mistakes of mid-2008:

Macroeconomic Advisers (2008b, 1), managed by former Fed governor Laurence Meyer and whose publications discuss monetary policy through the perspective of credit markets rather than money creation, also argued that monetary policy was restrictive: "Over the period that ended in April [2008], the FOMC strategy was to ease aggressively in order to offset the tightening of financial conditions arising from wider credit spreads, more stringent lending standards, and falling equity prices. We said that the FOMC was 'running to stand still,' in that those actions did not create accommodative financial conditions but were needed to keep them from becoming significantly tighter. Since the last easing [April 2008], however, the FOMC has abandoned that strategy. Financial conditions have arguably tightened more severely since April than during the earlier period, and yet there has been no policy offset. This pattern has contributed importantly to the severe weakening of the economic outlook in our forecast."
At the time, people tended to assume that the US recession spread to the rest of the world. Indeed Europeans initially blamed their slump on reckless financial policies in the US. And yet Hetzel points out that real GDP was already falling by the second quarter of 2008 in Britain, Japan and the Eurozone, while in the US real output actually rose in Q2:
In 2008, all the world's major central banks introduced inertia in their interest rate targets relative to the cyclical decline in output. The European Central Bank (ECB) focused on higher wage settlements in Germany, Italy, and the Netherlands (Financial Times 2008) and in July 2008 raised the interbank rate to 4.25 percent. Although annualized real GDP growth in the Euro area declined in 2008:Q1, 2008:Q2, and 2008:Q3, respectively, from 2.8 percent, to −1 percent, to −1 percent, the ECB began lowering its bank rate only on October 8, 2008. In Great Britain, the Bank of England kept the bank rate at 5 percent through the summer, unchanged after a quarter-point reduction on April 10. From 2007:Q4 through 2008:Q3, annualized real GDP growth rates in Great Britain declined, respectively, from 2.2 percent, to 1.6 percent, to −.1 percent, and then to −2.8 percent. (The Bank of England also lowered its bank rate by 50 basis points on October 8, 2008.) In Japan, for the quarters from 2007:Q4-2008:Q3, annualized real GDP growth declined from 4.0 percent, to 1.4 percent, to −4.5 percent, to −1.4 percent. The Bank of Japan kept its interbank rate at .5 percent, unchanged from February 2007, until October 31, 2008, when it lowered the rate to .3 percent. The fact that the severe contraction in output began in all these countries in 2008:Q2 is more readily explained by a common restrictive monetary policy than by contagion from the then still-mild U.S. recession.

In early fall 2008, the realization emerged that recession would not be confined to the United States but would be worldwide. That realization, as much as the difficulties caused by the Lehman bankruptcy, produced the decrease in equity wealth in the fall of 2008 as evidenced by the fact that broad measures of equity markets fell by the same amount as the value of bank stocks.

Indeed Hetzel points out that financial markets were relatively stable in mid-2008, when the recession intensified dramatically:

Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008. By then, U.S. financial markets were reasonably calm. The intensification of the recession began before the financial turmoil that followed the September 15, 2008, Lehman bankruptcy. Although from mid-2007 through mid-December 2008, financial institutions reported losses of $1 trillion dollars, they also raised $930 billion in capital--$346 billion from governments and $585 billion from the private sector (Institute of International Finance 2008, 2).
I'd add that in mid-2008, most economists were forecasting growth in 2009, despite being well aware of the subprime fiasco. Hetzel also shows that bank lending during 2008 was typical of a recession, despite widespread assumptions to the contrary:
In this recession, unlike the other recessions that followed the Depression, commentators have assigned causality to dysfunction in credit markets. For example, Financial Times columnist Martin Wolf (2008) wrote about "the origins of the crisis in the collapse of an asset price bubble and consequent disintegration of the credit mechanism. . . ." This view implies a structural break in the cyclical behavior of bank lending: In the current recession, bank lending should have been a leading indicator and should have declined more significantly than in past recessions. However, Figure 1, which shows the behavior of real (inflation-adjusted) bank loans in recessions, reveals that bank lending behaved similarly in this recession to other post-war recessions. Moreover, the fact that bank lending rose in the severe 1981-1982 recession and often recovered only after cyclical troughs suggests that bank lending is not a reliable tool for the management of aggregate demand.
Hetzel also criticizes the Fed's reliance on policies aimed at fixing the credit markets, while ignoring the shortfall in nominal spending (and compares this to the (ineffectual) Reconstruction Finance Corporation of 1932.) In an appendix, he points to a similar misapprehension regarding the Great Depression:
The experience of the Depression casts doubt on the credit-cycle view, which emphasizes the disruption to real economic activity from the loss of banks and the resulting loss of information specific to particular credit markets. Ex-Fed Governor Frederic Mishkin (2008) expressed this idea:
In late 1930...a rolling series of bank panics began. Investments made by the banks were going bad. . . .Hundreds of banks eventually closed. Once a town's bank shut its doors, all the knowledge accumulated by the bank officers effectively disappeared. . . .Credit dried up. . . .And that's when the economy collapses.
However, the implications of this view conflict with the commencement of vigorous economic recovery after the business cycle trough on March 1933 and the occurrence of widespread bank failures in the winter of 1933 and the additional permanent closing of banks after the Bank Holiday in March 1933. During the Bank Holiday, which lasted from March 6 through March 13-15, the government closed all commercial banks, including the Federal 228 Federal Reserve Bank of Richmond Economic Quarterly Reserve Banks. Before the holiday, there were 17,800 commercial banks. Afterward, ". . . fewer than 12,000 of those were licensed to open and do business" (Friedman and Schwartz 1963a, 425). Friedman and Schwartz (1963a, Table 16, 438) list "Losses to Depositors per $100 of Deposits Adjusted in All Commercial Banks." In 1930, 1931, and 1932, the numbers are, respectively, .6 percent, 1.0 percent, and .6 percent. For 1933, the year in which cyclical recovery began, the number rose to 2.2 percent.
If banking turmoil was actually such a drag on the economy, why did the US experience explosive growth in 1933, during perhaps the worst banking crisis in American history?

In my view Hetzel's 2009 paper will eventually be viewed as the definitive contemporaneous account of the mistakes made by monetary policymakers in 2008, as well as the broader misdiagnosis of events by the profession as a whole. I strongly recommend that you read the whole thing. Even better, take a look at his 2012 book entitled The Great Recession. The fact that these studies were produced by someone working within the Federal Reserve System (where not being a team player is highly discouraged), makes them even more impressive.

Comments and Sharing

COMMENTS (12 to date)
E. Harding writes:

"If banking turmoil was actually such a drag on the economy, why did the US experience explosive growth in 1933, during perhaps the worst banking crisis in American history?"

-During!? I thought it was immediately after its end.

Scott Sumner writes:

E. Harding, The claim is that the closure of banks reduces intermediation. Well FDR closed 1000s of banks in early 1933, and they remained closed even after the bank holiday ended, indeed throughout the March to July boom in industrial production.

ThomasH writes:


I wish you would pull together all this in a blow by blow critique of Fed actions and inactions 2007-2015, based on information available at the time.

When should interest rates have gone to zero? When should QE in what amounts have been begun? How should these actions have been explained?

I suspect you'll need multiple starting points. Since the Fed did not do X1 in month Y of 2007, in month Z of 2008 we were in situation Q which called for doing X2. But since they did not do X2, by Month W of 2009 we were in situation R when they should have done X3 .... all the way down to not raising rates in December 2015.

Without these specifics, people not already "in on" your analysis can think the Fed was doing everything possible but was overwhelmed by events. This is, I'm sure you agree, the false narrative that's about in "media macro." Think of this request as asking for "talking points" to confront that narrative.

And BTW, for my taste at least, don't try to refute head on whether what the Fed did was or was not "extraordinary" "massive" or "unprecedented." In many ways its actions were "extraordinary" "massive" and "unprecedented," just not "extraordinary" "massive" and "unprecedented" enough.

Happy New Year.

ThomasH writes:


And if you would explain as well WHY the Fed did not take the actions at each point you think it should have, that would be nirvana. As you know, I think it was much more political opposition from the "audit the Fed" - goldbug - "hyperinflation is around the corner" gang than the Fed not yet having cottoned onto the desirability of a NGDP target. But you tell me.

Maybe I'm asking for your next book. If so, hurry!


I dare not ask you to include what the fiscal policy response should have done at each point when the Fed repeatedly dropped the ball. Leave that to Paul Krugman. :)

Scott Sumner writes:

Thomas, The fiscal question is easy, I don't think more would have helped. As we saw in 2013, when the fiscal authorities do less, the Fed does more.

The problem with the suggestion for a more complete set of concrete steps is that the real problem was that the Fed had the wrong target. They were targeting the growth rate of prices, instead of the level of NGDP. But even assuming that criterion they failed. I often point to the meeting after Lehman failed, where they refused to ease monetary policy, despite a huge drop in TIPS spreads.

If the Fed had had the right target, then it's quite possible they never would have had to cut rates to zero. That's why it's misleading to talk about policy failure in the language of interest rate changes.

I am working on a book based on my blog, but unfortunately it's a slow process. Until then, my paper "The Real Problem Was Nominal" gives an overview of my take on the recession.

Jim Glass writes:

> I am working on a book based on my blog...

I just finished "The Midas Paradox", two thumbs up!

Looking forward to your next.

Scott Sumner writes:

Thanks Jim.

ThomasH writes:


I'm not asking you to prescribe Fed policy in interest rate terms. I meant, starting whenever you wish, tell us what the Fed should have done -- bought ST assets, bought LT assets, bought FX, whatever (and explained what it was doing) -- based on the information it had if it had had the right target. Then you can say the Fed caused the recession because they did X1, X2, X3 ... instead of Y1, Y2, Y3.

Benjamin Cole writes:

Sad that the Fed is so ossified it cannot alter its goals---even so minor an adjustment to, say, an inflation band rather than an IT is inconceivable.

Which brings up a question: is this Fed willing to embrace a bad monetary policy in order to preserve its independence?

Is that what the Fed is doing?

Gary Anderson writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

Scott Sumner writes:

Thomas, The Fed should have always done enough open market purchases so that their own internal forecast of 12 month forward NGDP rose smoothly along a 5% growth trend line. I'm not privy to their internal models, so I can't say how much that would have been. But their own forecast showed NGDP growth falling well short in 2009, so by that criterion money was too tight, especially after mid-2008.

ThomasH writes:


On the "easy" fiscal question, does this not make any sense at all?

Comments for this entry have been closed
Return to top