Scott Sumner  

Sorry, I don't get the joke

Democratic ideology unchained... Em Bet?...

In January 2008, the US economy had fallen into recession and Ben Bernanke was already supportive of fiscal stimulus:

Ben S. Bernanke, chairman of the Federal Reserve, has told lawmakers that he can support tax cuts or spending measures to stimulate the economy, even if they increase the budget deficit, provided the measures are quick and temporary.

Mr. Bernanke is to testify before the House Budget Committee Thursday. Democratic lawmakers said he had told them that he would not comment on proposals to link a stimulus package with a permanent extension of President Bush's tax cuts. That is expected to disappoint Republicans who favor such a link.

Faced with growing evidence that the economy is slipping into a recession, Congressional Democrats and President Bush are trying to come up with a package that would put more money in Americans' hands within the next few months.

The Fed's willingness to give a nod to fiscal stimulus is important. Many lawmakers will not support action without the chairman's blessing, and the double dose of stimulus that the Fed and Congress are considering must be carefully calibrated.

Question: If Fed officials think the economy needs fiscal stimulus, why not instead adopt a more expansionary monetary policy?

By August 2008, the unemployment rate had soared to 6.1%, up 1.7% from the 4.4% low of the previous expansion. Since record keeping began in the 1940s, the unemployment rate has never risen by more than 0.8% without a recession. Not once. And it was already up 1.7 percentage points, a clear indication of recession. Indeed by August the recession was already almost as bad as the 1980 recession where unemployment rose by a total of 2.1%.

The Fed knew all this when they met on September 16th, and they also knew that Lehman had failed, that AIG was failing, that Fannie and Freddie were in such dire straights that they had to be taken over by the Federal government. So how did the Fed respond to this crisis? Before I tell you let me point out that if you ask 200 economists, 90% will tell you that they were "doing all they could". In fact, the Fed did nothing at all. They sat around the table cracking jokes and warning of inflation if policy got too expansionary. They did not cut interest rates (from 2.0%). Then in early October they adopted interest on reserves in order to raise interest rates---with the intention of tightening monetary policy. Marcus Nunes provides some excerpts from the infamous September meeting in the comment section of my previous post:

The 2008 "Dream Team"
Either the financial system is going to implode in a major way, which will lead to a significant further easing, or it is not.
But I should follow the philosophy of Charlie Brown, who I think said, "Never do today what you can put off until tomorrow." [Laughter]
Deleveraging is likely to occur with a vengeance as firms seek to survive this period of significant upheaval... I support alternative A to reduce the fed funds rate 25 basis points. Thank you.
I also encourage us to look beyond the immediate crisis, which I recognize is serious. But as pointed out here, we also have an inflation issue. Our core inflation is still above where it should be.
MS YELLEN. I agree with the Greenbook's assessment that the strength we saw in the upwardly revised real GDP growth in the second quarter will not hold up. Despite the tax rebates, real personal consumption expenditures declined in both June
and July, and retail sales were down in August. My contacts report that cutbacks in spending are widespread, especially for discretionary items. For example, East Bay plastic surgeons and dentists note that patients are deferring elective procedures. [Laughter]
Meanwhile, an inflation problem is brewing. The headline CPI inflation rate, the one consumers actually face, is about 6ΒΌ percent year-to-date...My policy preference is to maintain the federal funds rate target at the current level and to wait for some time to assess the impact of the Lehman bankruptcy filing, if any, on the national economy.
As I said, it is my view that the current stance of policy is inconsistent with price stability in the intermediate term and so rates ultimately will have to rise.
Given the lags in policy, it doesn't seem that there is a heck of a lot we can do about current circumstances, and we have already tried to address the financial turmoil. So I would favor alternative B as a policy matter. As far as language is concerned with regard to B, I would be inclined to give more prominence to financial issues. I think you could do that maybe by reversing the first two sentences in paragraph 2. You would have to change the transitions, of
But I think we should be seen as making well-calculated moves with the funds rate, and the current uncertainty is so large that I don't feel as though we have enough information to make such calculations today.
Given the events of the weekend, I still think it is appropriate for us to keep our policy rate unchanged. I would like more time to assess how the recent events are going to affect the real economy. I have a small preference for the assessment-of-risk language under alternative A.
In fact, it's heartening that compensation growth is coming in a little below expected in response to the energy price shock this year. This has allowed us to accomplish the inevitable decline in real wages without setting off an inflationary acceleration in wage rates.
I think what we did with Lehman was the right thing because we did have a market beginning to play the Treasury and us, and that has some pretty negative consequences as well, which we are now coming to grips with.
I think it's too soon to know whether what we did with Lehman is right. Given that the Treasury didn't want to put money in, what happened was that we had no choice...I hope we get through this week. But I think it's far from clear, and we were taking a bet, and I hope in the future we don't have to be in situations where we're taking bets.
Mr. FISHER. All of that reminds me--forgive me for quoting Bob Dylan--but money doesn't talk; it swears. When you swear, you get emotional. If you blaspheme, you lose control. I think the main thing we must do in this policy decision today is not to lose control, to show a steady hand. I would recommend, Mr. Chairman, that we embrace unanimously--and I think it's important for us to be unanimous at this moment--alternative B
Those would be my suggestions to try to strike that balance--that we are keenly focused on what's going on, but until we have a better view of its implications, we are not going to act.

By late October the entire global economy was in free fall. The US stock market had crashed and commodity prices were plunging. Indeed almost all asset classes were plunging, except the US dollar, which was appreciating strongly on the Fed's tight money policy.

On October 20, Ben Bernanke was asked if the US economy was in recession:

Pressed to say whether he thought the economy was in a recession, Bernanke refused to say. "We are in a serious slowdown in the economy, which has very significant consequences for the public, and whether it's called a recession or not is of no consequence."
But that caution did not stop him from again calling for fiscal stimulus:
WASHINGTON (MarketWatch) -- Another shot of fiscal stimulus may be needed now to help the U.S. economy recover from what could be a drawn-out slowdown, Federal Reserve Chairman Ben Bernanke said Monday.

"With the economy likely to be weak for several quarters and with some risk of a protracted slowdown, consideration of a fiscal package by the Congress at this juncture seems appropriate," he told legislators on the House Budget Committee. . . .

It was the second time this year that Bernanke had endorsed a fiscal-stimulus program, a rare admission from the central bank that monetary policy can't fix the economy by itself. . . .

Repeating the same general principles called for in January, Bernanke said any new plan should be designed to be timely, temporary and targeted.

The Fed chief suggested that Congress should include "measures to help improve access to credit by consumers, home buyers, businesses and other borrowers." Under questioning, Bernanke said Congress could support the credit picture with guarantees, tax credits or even direct lending.

I guess "monetary policy can't fix the economy by itself" if the Fed isn't even trying.

To summarize, in both January and September the economy was doing so poorly that fiscal stimulus was called for. But when the Fed considered whether it should do anything at the pivotal September meeting, all we got were some lame jokes.

And even when the Fed finally got around to cutting rates, the cuts were far too timid. At no time during the Great Recession was the Fed doing it all it could.

PS. The October 20 piece also has an unfortunate example of Bernanke "reasoning from a price change":

He said that household-purchasing power should be boosted by the recent declines in prices of oil and other commodities, calling the trend a "bright spot."
Commodity prices were plunging precisely because the global economy was in free fall. Hardly a bright spot.

PS. Don't read this post as being about Bernanke, almost the entire economics profession (including the FOMC) was basically on board with what the Fed was doing, or not doing.

Comments and Sharing

COMMENTS (10 to date)
Steve F writes:

Great post, Scott. Question:

Why was the Fed so timid? Was it because the regime was targeting inflation, which led to tightening policy due to oil price upward pressure on inflation? Was it that the Fed viewed where it sets the nominal interest rate as the stance of its monetary policy? What caused the Fed (and the economics profession) to get this situation wrong?

Jake writes:

In my view there have really only been three major discoveries in the field of macro.

1) Smith discovers the value of free markets and the "invisible hand".

2) Keynes pioneers the concept of AD and explains that nominal variables have real effects in the short run.

3) Everyone admits Keynes was right but his preferred policy instrument -- fiscal policy -- is wrong. Monetary policy is actually the correct tool to manage the nominal economy and it is both necessary and sufficient for the task.

Unfortunately most economists have forgotten #3 which is why the Great Recession happened. Now only the market monetarists have the right model via managing NGDP and its expected growth path.

This is an oversimplification of course but if I had to explain the last ten years to someone in an elevator, that would be my pitch. Thoughts?

Kevin Erdmann writes:

I used to see the Fed calls for fiscal stimulus as incoherent. But reading this post, it seems like a desperate way to do an end around the FOMC hawks.
Unfortunately, as Bernanke was making that plea for lending,the federal GSES were almost completely cutting off lending to all but the most qualified borrowers.

LK Beland writes:

Indeed, in September 2008, inflation had been high and unemployment was rising.

NGDP was crashing, but we didn't have access to that information in real time. A nice surrogate (and probably the most important variable for the labor market) is total wages (i.e. average weekly wages * total payrolls).

It's very clear that its growth rate had significantly slowed down starting at the end of 2007. Total wages were flat from March to August 2008. And started crashing in September. This data was available in real-time.

BTW, since 2009, total wage growth has been remarkably stable at 4%.

Mr. Econotarian writes:

Cut them some slack - they still did better than 1929!

I suspect the feeling of finally taming inflation for the long-run was addicting, and they were scared of breaking their "winning" streak.

Next time I'm sure they'll do better...

Benoit Essiambre writes:

Inaction might prevent vast amounts of people from working for subsistence and cause the downfall of western liberal capitalism but lets not risk wages and prices going up a bit lol.

Scott Sumner writes:

Steve F. There are many factors:

1. Targeting inflation instead of NGDP.

2. Reasoning from a price change (assuming falling rates meant policy was easing.)

3. Not targeting the forecast---allowing forecast NGDP growth to fall sharply.

4. Sluggish response of interest rates, which were cut much too slowly, as the Fed prefers gradualism.

5. Misdiagnosing the problem, assuming banking turmoil was "the problem" whereas it was a symptom of falling NGDP expectations.

Jake, I'd add that even before Keynes many economists knew that nominal shocks had real effects. Hume wrote on that issue in 1752.

Kevin, That could be.

LK, Good points. Note that inflation expectations (TIPS spreads) were plunging in September 2008.

Mr, Econotarian, That's true, just as Bush's mistake in Iraq was less severe than Johnson's in Vietnam. But still pretty bad.

Majromax writes:

I think your answer is right there in the transcript:

Given the lags in policy,

The Fed sees monetary policy as acting with 'long and variable lags', rather than with immediate effect. From that perspective, it is not appropriate to use monetary policy to address a current crisis; it has to think about setting policy today for the expected state of inflation a year or so out.

I know you think this view is plainly wrong, but the Fed does not and it sets policy from its own framework. You'd be hard-pressed to set interest rate policy for NGDP targeting if you had to commit today to actions undertaken with a year's delay. (In fact, from mathematical control theory, acting with a delay can be explosively unstable if the target is too tight!)

Fiscal policy is seen as free of these constraints, since it can effect (and affect) demand at the stroke of a pen.

Brian Donohue writes:

Great post, Scott. I agree that the employment and wage indicators were flashing the loudest, but by 9/16/2008, the Fed had already released the first of what would become 5 consecutive months of negative inflation reports, composing the biggest drop in CPI since WWII. 1-month doesn't make a trend, but it was at least suggestive that the inflation seen in the first half of the year had been broken, and presumably the Fed had more inside information pointing in this direction if their tools are any good at all.

But inflation...

Scott Sumner writes:

Majromax. Stern may believe that but the Fed surely knows better. They moved right after the 1987 stock market crash, for instance, and frequently respond to shocks as if policy impacted the economy quickly. Other examples include the Fed's aggressive moves in September 2007 and January 2008, which Bernanke believe staved off recession for a period of time.

Bernanke's a student of the Great Depression, he knows that the economy took off immediately after FDR devalued the dollar.

Fiscal policy is often quite slow, as Congress haggles over the specifics for months on end.

Brian, Yes, and the Fed didn't need inside information, the markets were clearly predicting deflation.

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