Matt Yglesias and Karl Smith on the real problem with Fed policy

Arnold Kling directs us to this great sentence from Matt Yglesias:

But I’m not sure Ben Bernanke, Tim Geithner, and the others were in fact making any major mistakes in 2006 beyond underestimating how inept they would be in the fall of 2008 and the winter of 2008-9.

Karl Smith quotes from the same Yglesias post:

[Residential Construction] enters negative territory in the last quarter of 2005. Then it stays negative all four quarters of 2006, and during all this time the FOMC members are making statements about how the economy should survive the housing bust. Then it’s negative for four more quarters throughout 2007. And then for the first two quarters of 2008. And all that time from the latter part of 2005 through all of 2006 and 2007 and through the beginning part of 2008, the Federal Reserve is basically doing its job correctly.

Then Karl adds some very perceptive observations:

You can see that by the time the recession hit the Housing-Export complex was actually adding to growth.

Now, why is this an important complex to look at?

Because, as many commenters have noted the boom in residential construction was in large part financed by large external deficit. We borrowed money from the Chinese (and Germans and Japanese) to build a bunch of homes in the United States.

However, the way you borrow money from other countries is by running a trade deficit. As residential construction shrank, so did the trade deficit. This provided the economic offset that kept the economy from going into recession in 2005 as residential construction rolled over.

By the beginning of 2008 though other sectors of the economy – notably non-residential construction and manufacturing, were beginning to weaken. This tipped the economy into recession.

During that 2 and 1/2 year period the value of the dollar fell sharply, which helped re-balance the economy away from housing and toward exports.  That’s exactly how market economies are supposed to work, and it’s exactly how market economies do work.  Unless . . .

Suppose that the Fed takes its eye off NGDP growth and becomes obsessed with transitory increases in commodity prices that are having no effect on NGDP growth.  And suppose they tighten policy sharply, causing the dollar to soar by 15% in trade weighted terms between July and December 2008.  What then?

Then NGDP falls at the sharpest rate since the Great Depression, and RGDP also plunges.  An “unnecessary recession” as Tim Congdon put it in June 2009 (long before most other people came to that realization.)  Patterns of unsustainable specialization and trade were being rearranged quite effectively, as long as NGDP kept growing.

Forget about the Fed minutes from 2006, we’ll have to wait two more years for the real juicy stuff.  I can’t wait to read what Richard Fisher had to say in September 2008.

PS.  Karl Smith’s post has some good graphs.


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22 Responses to “Matt Yglesias and Karl Smith on the real problem with Fed policy”

  1. Gravatar of Benjamin Cole Benjamin Cole
    15. January 2012 at 11:14

    BTW, as a washed-up real estate-financial journalist, I have something important to add here: Why does everybody blah-blah endlessly about the residential single-family home price collapse, but never mention the equal and parallel collapse in nearly all sectors of commercial real estate?

    At the top, lenders and mezzanine financiers were bragging about “how high they could go in the capital stack.” It meant commercial buyers could acquire property for as little as 5 percent equity and sometimes even less.

    http://mit.edu/cre/research/credl/rca.html

    As you can see from the above chart, commercial properties had values cut in half in the Great Recession!!!

    This mirror collapse in commercial property markets strongly suggests it was the Fed, not Fannie and Freddie, that cratered property markets. There was a leveraged boom in real estate—globally as well.

    At some point that Fed tried to fight global commodity price inflation through US monetary policy. The result was the Great Recession—and commodity prices are back about where there were. So you can obtain temporary victories over commodities prices at the cost of ramming a torpedo into the US economy.

    But hey–the Theo-Monetarists say the goal of monetary policy is not prosperity but zero inflation. So it was worth it.

  2. Gravatar of Jon Jon
    15. January 2012 at 11:44

    Scott, what an Austrian analysis from the three of you!

    First we have a housing boom driven by credit expansion. Then credit tightens, boom ends. Dollar depreciates reflecting lower wealth for the country.

    You then present the alternative where the CB could tighten to avoid the dollar depreciation. Of course this is precisely what would have happened under a gold regime. Then as you day, we would have had unemployment.

    Looks like the Austrian story dead on.

  3. Gravatar of Morgan Warstler Morgan Warstler
    15. January 2012 at 12:04

    HOUSING. PRICES.

    For 4 years the Fed has been focused on housing prices and CONTINUES to be focused on housing prices…. recent note to Congress was about… housing.

    Greenspan has been completely focused out loud on housing, and you think they were motivated by commodity prices?

    Inflation over 2% worries them, and the fall in home prices worries them.

    If you put these two things together, you get a Fed that prefers to stabilize the housing market while prices in everything else go down.

    Not an easy task, huh?

    But IF you were going to try and achieve it, what would you do?

    You’d radically expand fossil fuel production in the US, you’d pass the pipeline deal, you’d put wage pressure on the population and public employees directly, you’d reduce tariffs…

    These are the goals of which Presidential candidate?

    Granted, I can’t figure out why they care so much about housing prices, but it is UNARGUABLE that this is the Fed’s biggest concern.

    Note: If I had to guess why the Fed cares, I’d say because the prime loans are held by the top 20% of America that consumes 80% of everything, and as long as they aren’t jungle mailing the keys, they will keep America’s consumption up.

  4. Gravatar of Steve Steve
    15. January 2012 at 12:22

    I, too, look forward to reading what Fisher had to say, but I imagine we already know. In 2008 he’d be saying the same as in 2006: it’s a bicoastal problem, Texas is still strong, trimmed mean PCE is above target, look at China and all their oil consumption. In 2009 he’d echo Allan Meltzer: it’s a garden variety recession, we’ll come back strong, and this QE stuff will produce hyperinflation.

  5. Gravatar of D R D R
    15. January 2012 at 13:01

    Jon,

    I think Scott was suggesting the Fed should have loosened in order to prevent dollar appreciation, not tighten to prevent dollar depreciation.

    As much as I have argued with Scott elsewhere, I basically agree and have argued as much (including the CRE boomlet) The missing piece of the puzzle is why there was a sudden appreciation in the dollar?

    While the dollar depreciation was needed to rebalance trade, we do have trading partners in Europe who were losing exports. As European trade balances fell, how did savings and investment balance? Was there capital flight from Europe as the economy tanked? If so, could the Fed have prevented said capital flight?

    So many interesting questions…

  6. Gravatar of Jon Jon
    15. January 2012 at 13:32

    DR, who is talking about tightening? That’s Internet Austrian thinking. My point is much more subtle. Scott said that depreciation was a natural market consequence of retrenchment in the housing market. My point was that he was making a twin shoals argument. Either you let the dollar depreciate, in which case Americans are objectively less wealth and have less income than before (surely that is not a pleasant outcome on its own terms) or you tighten policy to salvage the value ofthe dollar and induce unemployment. That also makes Americans poorer internationally–the dollar is as valuable but NGDP falls.

    Under a gold peg, the CB would be forced into the latter. So domestic unemployment would be an inevitable consequence of the adjustment.

    But that is NOT the theoretic conclusion of Austrian analysis. The theory merely says that the net of unsustainable credit expansion is to make the country poorer. Scotts and Karls little story here is really regardless of the policy choice after the fact, the country is poorer than it expected to be.

    People don’t realize how deeply Austrian origins of everything that’s right in modern economics. That’s because the austrians won the arguments long ago. Sadly people focus on certain gold peg predicated analyses of yore and fault the conclusions. It’s a shame a good analytic framework gets abused by people who don’t understand te argument fully but that doesn’t make the framework wrong.

  7. Gravatar of Donald Pretari Donald Pretari
    15. January 2012 at 13:45

    “In the 1933 article Fisher emphasised the sometimes paradoxical nature of this downward spiral. People repay bank debt in order to improve their financial circumstances, but — if everyone does so at the same time — the resulting fall in bank deposits (ie, in the quantity of money) causes a drop in prices and possibly an increase in the real value of the remaining debts. To quote from him again, “the mass effort to get out of debt sinks us more deeply into debt”.

    “What is the likely sequence of events? First, pension funds, insurance companies, hedge funds and so on try to get rid of their excess money by purchasing more securities.”

    “Secondly, once the stock market starts to rise because of the process just described, companies find it easier to raise money by issuing new shares and bonds.”

    I’m pretty sure this is exactly what I’ve been arguing is the QE part of the Chicago Plan of !933 since 08. But, since I’m no genius, I could be wrong.

  8. Gravatar of ssumner ssumner
    15. January 2012 at 13:47

    Ben, Thanks for that graph. The price of commercial real estate mirrors NGDP quite closely (albeit the fluctuations are bigger.) This tells me that the fall in commercial real estate was almost 100% tight money. Elsewhere I’ve argued that the original sub-prime price declines weren’t tight money, but the later part of the decline which spread to all markets was tight money. The commercial RE data supports that, as commercial RE fell just as the subprime crisis morphed into a nationwide problem.

    Jon, I don’t think most Austrians would agree, but I hope you are right.

    Morgan, I really doubt that Bernanke is some sort of evil genius, and that the housing collapse played out just as the Fed wanted. The Fed is now sending letters to Congress asking them to use F&F to prop up the housing market. Is that your preference?

    Steve, Yes, but he tends to use colorful language, so it may be entertaining.

    DR, Yes, I think your correction to Jon was right. I have a hunch that the strong dollar was partly due to the demand for liquidity during financial turmoil. Because the Fed failed to accommodate that demand, money became very tight.

    Jon, OK, that is a much more sophisticated Austrian argument. But I don’t think you can claim that other economists ignore that. Surely everyone agrees that if lots of useless houses were build, living standards may need to adjust downward a bit. It’s just that in previous business cycles it wasn’t obviously a huge problem, except perhaps 2001, when tech was overbuilt.

  9. Gravatar of ssumner ssumner
    15. January 2012 at 13:49

    Donald, Yeah, that’s one way out. But I don’t think the fiscal part adds much.

  10. Gravatar of Donald Pretari Donald Pretari
    15. January 2012 at 14:53

    Scott, The Fiscal Part is Reinforcing. But there is going to be Govt Spending & Borrowing in any case because:
    1. You don’t want to raise taxes.
    2. You don’t want mass firings.
    3. You’re going to give some kind of benefit to people suffering.
    4. The Govt will still do some things.
    The Govt Borrowing Reinforces Inflation/Reflation. All the arguments are really about how much should the Govt Borrow & what should the Govt Spend it on. To the extent that QE Works, there will obviously be less need of its being reinforced.

  11. Gravatar of bob bob
    15. January 2012 at 15:40

    I’d love to hear how this same principles apply to the European recession in the same period. Did the ECB throw the PIIGs under the bus, or was fiscal policy the culprit in some cases?

  12. Gravatar of Morgan Warstler Morgan Warstler
    15. January 2012 at 15:47

    Scott, two posts in a row, you are a horrible reader.

    MY COMMENT said, Ben is now sending letters worrying about housing prices BECAUSE he has ONLY been worried about two things for the last 4 years: housing prices and inflation over 2%.

    You then read the rest of my post to deduce that SINCE these are the two things Ben cares about – Ben has a BIAS in the coming election.

    And so does the rest of most of the Fed.

    That doesn’t make him an evil genius, it make him PREDICTABLE.

  13. Gravatar of Morgan Warstler Morgan Warstler
    15. January 2012 at 15:51

    bob, Scott is willing to admit that the ECB is intentionally bitch slapping the PIIGs, but he can’t bring himself to think our holy Fed behaves the same way.

    The bias of the Fed is a fact. It is an awesome kick-ass bias we can cheer. And anyone who doesn’t admit it, doesn’t get to play the rational expectations game…, because they are obviously a bad judge of rational.

    Fed bias is THE rational expectation.

  14. Gravatar of D R D R
    15. January 2012 at 16:47

    Jon, Scott

    I would point out the dollar had been falling during the worst of the run-up in housing. The real broad dollar peaked way back in Feb 2002 and fell 15 percent over the next three years.

    http://www.federalreserve.gov/releases/h10/summary/indexbc_m.htm

  15. Gravatar of Jon Jon
    15. January 2012 at 23:07

    Scott remarks: “Jon, I don’t think most Austrians would agree, but I hope you are right.”

    Well at least I have Hayek, and he is the Nobelist of the bunch!

    Then Scott remarks: “Jon, OK, that is a much more sophisticated Austrian argument. But I don’t think you can claim that other economists ignore that. Surely everyone agrees that if lots of useless houses were build, living standards may need to adjust downward a bit. It’s just that in previous business cycles it wasn’t obviously a huge problem, except perhaps 2001, when tech was overbuilt.”

    No they don’t ignore that. Suppose though that we’re targeting NGDP. Suppose then that there are pervasive malinvestments. What does that mean? If the real rate-of-return is less than anticipated in the aggregate then the CB will have increased the inflation-rate to maintain the nominal rate-of-return in the aggregate. The country is meanwhile getting poorer compared to an alternative P/Y split. Having avoiding the recession, what’s the incentive to liquidate? Is it the same or attenuated?

    Since time is money, it would seem to matter a great deal to prosperity how long this would take. I would figure the time-constant to be comparable to moving inflation expectations to the new steeper path…

    The meta problem in society is figuring how to allocate capital to the highest returning activities. The origin of the Austrian attack on the banking system is the claim that while one man might closely figure the rate of return of his present projects, he relies on the prevailing rate of interest to figure whether his activities have a return above or below the marginal return of the aggregate.

    So if the CB tightens, this process of liquidation would tend to be accelerated; However, given that a tightening of the interest-rate would lower the rate of the inflation, we might then fear the loss of real output due to unemployment is worse. i.e., we lose more output due to unemployment than the output lost from not perceiving we’re on the wrong growth path.

    So goes the Hayekian version: some tightening can be good, e.g., you can drive a liquidation of malinvestments or stabilize the nominal growth path but you should avoid lowering the inflation below expectations and inducing unemployment due to a “secondary deflation”.

    The way I see it, a critique focused on the banking system made sense circa 1900 but does not now. The intellectual frame still applies; its just the balance of which factors matter more that’s changed. The process of capital investment used to be simpler (we had a ways to go with growth driven through heavy industry alone) and communication was much more limited.

    In our contemporary situation, the market rate of interest as a signaling tool is a less important factor. The risk of disinflation itself is therefore more paramount, but also the barriers to knowing how to efficiently allocate capital are greater now–the problem is more complicated. That’s why Klings PSST is a decent modern revival of the ‘local information’ problem.

  16. Gravatar of Jon Jon
    15. January 2012 at 23:11

    DR writes:

    I would point out the dollar had been falling during the worst of the run-up in housing. The real broad dollar peaked way back in Feb 2002 and fell 15 percent over the next three years.

    Well, it can be hard to disentangle effects. Something to consider: when the EURO was introduced, there was quite some doubt about the currency union and risk drove the euro down with respect to the dollar. It took some years for that effect to vitiate.

  17. Gravatar of TC TC
    16. January 2012 at 06:34

    The Dollar was spiking in 2008 due to people freaking out everywhere in the financial markets.

    By July of that year, everybody paying attention was talking about Lehman blowing up, and there being a massive crisis. I tried to get a friend in the media to do reporting on the potential for a global meltdown during the first half of 2008.

    In real time, nobody was talking about tight rates. People were worried about the end of the financial world. By August, rumors were flying everywhere about Bear and Lehman. BoA was tanking.

    I don’t think there were any rates that could have saved the situation at that point. The markets that ended up failing were nearly entirely rate indifferent. The haircuts on MBS began to go up rapidly starting in July – and I can assure you cutting rates would have had no effect.

    When the value of your collateral goes from nearly zero haircut to 50% hair cuts, it’s not a rate problem.

    The reason the USD gained so much wasn’t tight rates relative to the rest of the world. Rates in the U.S. were not fantastically tighter than they were in Europe. Rather, people were legitimately worried about the entire financial system failing.

    When credit stopped dead in September, there wasn’t something that could have been done in July to make it all go away beyond massive fed purchases of MBS that had only taken small losses at that point. The MBS used in the repo market were already dooooomed, but the prices didn’t reflect that doom at all.

    The level of fed action required to avoid the loss of NGDP in December 2008 was simply out of the question in July 2008.

  18. Gravatar of ssumner ssumner
    16. January 2012 at 11:30

    Donald, Yes some deficit spending is optimal in recessions–I’d say don’t go beyond that.

    Bob, Like in the US, it was some of each.

    Morgan, I honestly don’t follow. Are you saying Ben wants the Dems to win or the GOP? I thought you’d claimed the GOP, but now he wants to bail out housing.

    DR, True, but assets prices have zero momentum, so it doesn’t in any way undercut my observation. It fell from the unusually high level at the peak of the tech boom, to normal in 2006, and then fell well below normal after 2006.

    Jon, I really don’t see how you are contrasting me with Hayek–we both favored targeting NGDP. I should add that I’m so busy with the Krugman comments that I may not have done justice to your comment.

    TC, The Fed can always stabilize NGDP with level targeting. The main reason NGDP falls sharply in the short run is because future expected NGDP falls sharply.

  19. Gravatar of Michael Tolbert Michael Tolbert
    17. January 2012 at 14:24

    As I read the linked article, Tim Congdon’s argument is that bank recapitalization caused the financial collapse? Are you agreeing with Tim, and if so, could you please explain in more detail.

  20. Gravatar of ssumner ssumner
    17. January 2012 at 17:19

    Michael, I have no opinion on that. I agree with his view that overly tight money was the problem, and that monetary stimulus was needed, not credit policy or fiscal policy.

  21. Gravatar of D R D R
    17. January 2012 at 17:49

    “True, but assets prices have zero momentum, so it doesn’t in any way undercut my observation. It fell from the unusually high level at the peak of the tech boom, to normal in 2006, and then fell well below normal after 2006.”

    It was only meant as an observation.

    “I have a hunch that the strong dollar was partly due to the demand for liquidity during financial turmoil. Because the Fed failed to accommodate that demand, money became very tight.”

    Again, just observations… The dollar bottomed out in April 2008, at which time the effective fed funds rate was down around 2 percent. But the monetary base didn’t really move until several months later. So that seems plausible. We can’t give the Fed too much of a policy lag on nominal interest rates, but I’m sure there was quite a debate over inflation during this time.

    So yeah, it’s plausible that the Fed erred in not accommodating sufficiently. But I’m also not sure money alone as such was going to prevent a the meltdown of many a good financial institutions. The amount of garbage they had on their books was breathtaking, if not surprising. Getting those assets off their books and onto that of the Fed, and the GSEs… I dunno.

  22. Gravatar of ssumner ssumner
    19. January 2012 at 14:02

    DR, Too much to say here in a short comment, but the gist of my argument isn’t “Money alone” but “monetary policy alone” inclding very importantly a promise to do level targeting going forward to prop up NGDP in the out years, to prevent a sharp plunge in asset prices, which made the banking crisis worse. By assets I mean stocks, houses, commercial RE, and commodities. Especially the first three.

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