Matt O’Brien on the Fed’s mistakes during 2008

Matt O’Brien has a great piece in The Atlantic on what went wrong during 2008. Read the whole thing.  Because of grading responsibilities, etc, I haven’t had time to read all the minutes.  But the picture is pretty much what I would have expected.  Here is his conclusion:

What was to be done?

None of this was inevitable. The Fed could have ignored oil prices that summer, and told us it was ignoring them. And it could have saved Lehman that fall. It wouldn’t have been easy—or popular—but it wouldn’t have been impossible, either. That’s clear if you look at what Rosengren was saying in real-time. With that in mind, here’s a look at what the Fed could have, and didn’t do, to make the Great Recession a little less so.

1. Oil shock. Graded on a curve, the Fed did okay. At least it didn’t raise rates that summer like the ECB did. But on an absolute scale, the Fed could have done better. It could have done in 2008 what it did in 2011, when another oil spike came along: say that the increase in inflation was transitory, and they were focused on long-term inflation expectations instead.

Now, more dovish language that summer wouldn’t have saved the world. But it would’ve kept money a little looser. And that could’ve given the financial system a little more breathing room to keep raising capital, like the Fed had been doing before.

2. Lehman. There are three magic words in central banking: whatever it takes. The Fed did that with Bear. It didn’t do that with Lehman. It could have let Lehman become a bank holding company, which is what Lehman wanted, and what the Fed ended up doing for Goldman Sachs and Morgan Stanley a few weeks later. Or it could have given Lehman bridge financing to try to finish a deal after everything fell through on September 14th. None of these would have been popular decisions, but what’s the point of an independent central bank if it won’t do unpopular things to save the economy?

After the fact, the Fed has said that it couldn’t do these things, that it had no choice. But the transcripts show that it was a choice, and they knew it. Some of them thought nothing bad would happen. And they were happy about it in September—well, all but Rosengren—until they realized what a world-historical error it was.

A few comments:

1.  The flawed monetary regime (failure to level target NGDP) made these seemingly small tactical errors in mid-2008 much worse than they would otherwise have been.

2.  I am pretty sure Matt is not a market monetarist, or at least he’s more Keynesian on issues like fiscal stimulus than I am.  Thus it’s heartening to see the MM interpretation of 2008 become increasingly accepted by the mainstream press. When people like David Beckworth and I were starting out on this crusade, the notion that excessively tight money was the problem was almost laughed off the stage.  ”Interest rates were 2%, how can you claim money was tight in 2008?” Now the MM narrative is becoming increasingly accepted in the media.  That’s great news.

3.  Elsewhere Matt praises Frederic Mishkin.  He also directed me to a Hilsenrath piece that said Mishkin came off looking relatively bad in the transcripts.  But Hilsenrath was focusing on Mishkin’s jocular style.  If you look at content of his analysis he was ahead of most of his colleagues. (In terms of forecasting Rosengren seems to have been the best.)  I did a post over at Econlog a few days ago praising Mishkin’s farewell comments, but forgot that he had been equally brilliant at the final meeting of 2007.

4.  As you’d expect Marcus Nunes also has this period covered, in a thorough analysis.  Every once and a while someone tries to argue that Japan actually hasn’t done that poorly over the past few decades.  Marcus nicely shoots down that argument with this post.


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29 Responses to “Matt O’Brien on the Fed’s mistakes during 2008”

  1. Gravatar of John Becker John Becker
    1. March 2014 at 08:13

    To the Fed,

    Forget macro, stop undermining the market system by stepping in to avoid business failures. By doing that you destroyed all the benefits of a competitive system. The intervention into banking and finance in 2008 was the biggest economic mistake of my generation regardless of monetary policy. We are now stuck with a banking system in this country that is flat out broken and may never be fixed in my lifetime.

  2. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    1. March 2014 at 08:31

    ‘It could have let Lehman become a bank holding company, which is what Lehman wanted, and what the Fed ended up doing for Goldman Sachs and Morgan Stanley a few weeks later.’

    Yes, and it only had that authority thanks to Gramm, Leach, Blilely (1999) repealing the ‘affiliations provisions’ (#20 and #32)of the 1933 Banking Reform Act–what’s popularly called Glass-Steagall.

    Contrary to the popular wisdom of ‘the repeal’ of Glass-Steagall.

  3. Gravatar of ssumner ssumner
    1. March 2014 at 08:42

    John, You said:

    “To the Fed, Forget macro, stop undermining the market system by stepping in to avoid business failures.”

    Either that means nothing, or its completely insane. Are you advocating legalized counterfeiting? A fixed monetary base? Or some other silly policy?

    I completely agree about how we screwed up banking.

    Patrick, Very good point.

  4. Gravatar of Aidan Aidan
    1. March 2014 at 09:39

    Krugman is good on this, too: http://krugman.blogs.nytimes.com/2014/02/28/did-inflation-phobia-cause-the-great-recession/

  5. Gravatar of TravisV TravisV
    1. March 2014 at 11:12

    Brad DeLong makes some good points here:

    http://www.project-syndicate.org/commentary/j–bradford-delong-reads-the-federal-reserve-s-meeting-transcripts-from-2008-and-tries-to-explain-officials–mindset

    “The Fed of old usually had a charismatic, autocratic, professional central banker at its head: Benjamin Strong, Marriner Eccles, William McChesney Martin, Paul Volcker, and Alan Greenspan. When it worked – which was not always true – the chair ruled the FOMC with an iron hand and with the near-lockstep voting support of the governors. The views of the other members – with their varying backgrounds in banking, regulation, and elsewhere – were of little or no concern.

    But former Chairman Ben Bernanke’s FOMC was different. It was collegial, respectful, and consensus-oriented. As a result, there was a deep disconnect between Bernanke’s policy views, which followed from his analyses in the 1980’s and 1990’s of the Great Depression and Japan’s “lost decades,” and the FOMC’s failure in 2008 to sense what was coming and to guard against the major downside risks.

    So I find myself wondering: What if those who understood the nature of the crisis and those who did not had been compelled to make their cases to Bernanke in private? If Bernanke had then said, “This is what we are going to do,” rather than seeking consensus – that is, if Bernanke’s Fed had been like the old Fed – would better monetary-policy decisions have been made in 2008?”

  6. Gravatar of TravisV TravisV
    1. March 2014 at 11:21

    The problem with DeLong’s analysis: in Summer 2008, nearly the entire economics profession was behind the curve, not just eight members of the FOMC.

    Which deserves more fault: unwillingness to tolerate rapid growth in headline CPI or the New Keynesian approach to macroeconomic analysis in general?

  7. Gravatar of Major_Freedom Major_Freedom
    1. March 2014 at 13:04

    Matt O’Brien ignores the Fed’s mistakes before 2008

    FTFY.

    It is not true things went wrong only in 2008. The Fed was, necessarily so, making huge mistakes before 2008. This mistakes are why the economy shifted so suddenly 2008 and why the Fed is interpreted as being “caught off guard” or “asleep at the wheel” or “made a mistake at this time, but not before”.

    From 2001 to the crisis, the Federal Reserve System massively expanded credit from nothing. It doesn’t matter that NGDP was doing this or that. NGDP is not a reliable indicator of monetary policy. Not with a country with a large and persistent trade deficit. Countries with large trade deficits would, in a free market, experience declining domestic money supply, spending, and prices. Not stable NGDP growth. A stable NGDP growth in the context of a world market does not imply that there are no monetary influences leading to economic instability.

    Think of an individual firm in a country, vis a vis all firms in that country. If a fiat bank targeted demand for that one firm to grow at 5% per year, where that one firm for some reason bought and sold in its own currency, with a floating exchange rate of that currency with the currency or currencies the other firms are using, it will be able to to keep acquiring and using resources even if, in real terms with respect to the country economy, it is wasting resources.

    The best way for a firm that is making errors to cease making errors, is to experience nominal losses. For the currency it spends is less than the currency it earns.

    The same principle is true if we extrapolate from firm to country, and all country firms to all world firms. If a country’s demand is targeted, it doesn’t matter if its currency floats in the exchange markets with other countries. That country will be able to acquire and use resources even if, in real terms with respect to the world economy, it is wasting resources.

    A free market in money would be able to punish such errors, because there would be no domestic fiat money inflation to rescue the country from world competition in nominal terms.

    —————

    Regarding Japan, Nunes hasn’t shot down the claim that Japan has done better than many more inflationary economies. Japan has performed about average. They beat half the world since 1991.

    Why haven’t the more inflationary economies put Japan at the bottom?

  8. Gravatar of Mark A. Sadowski Mark A. Sadowski
    1. March 2014 at 14:16

    “…Thus it’s heartening to see the MM interpretation of 2008 become increasingly accepted by the mainstream press…Now the MM narrative is becoming increasingly accepted in the media…”

    Yes, in general the coverage by the press and the econblogosphere of the events of 2008 *has* changed a lot over the years. However, there are still pockets of those who try and downgrade Fed responsibility mostly in order to suggest that monetary policy is not as powerful as it is (ahem, Krugman, cough, cough). And there are those who of course never miss an opportunity to bash the Fed whether the criticism is warranted or not.

    On the other hand the 2008 Fed transcripts present very few opportunities for spin when you have Plosser demanding that the fed funds rate be raised at every meeting, Fisher fretting over the price of scotch, hops, bagles etc., Bullard worrying about headline inflation when TIPS spreads were collapsing underneath him, and Lacker doing a victory dance over the Lehmans bankruptcy. The story pretty much writes itself.

  9. Gravatar of Macroman Macroman
    1. March 2014 at 14:42

    Yes, it seems those that those fiscalist like Krugman that don’t want to believe in monetary policy will do whatever they can to discount what the Fed wrong did in 2008 and discount its power to do something now. Haters going to keep on hating. On 2008, They ignore evidence like this from Beckworth http://macromarketmusings.blogspot.com/2014/02/spawning-great-recession.html

  10. Gravatar of benjamin cole benjamin cole
    1. March 2014 at 16:05

    David Glasner does a excellent take on the Atlantic article…the word “inflation” is mentioned literally hundreds of times in the transcripts…dwarfing all other topics…the FOMC was obsessed with inflation, had a peevish fixation even as the financial system collapsed…explain to me again, why are these transcripts secret for five years? That is good government?

  11. Gravatar of John Becker John Becker
    1. March 2014 at 18:09

    Scott,

    I meant that the Fed’s interventions into commercial paper and other markets as part of the 2008 bailout was much more harmful to the economy than any mistakes they might have made regarding interest rates, quantitative, easing or forward guidance during that period.

  12. Gravatar of Benjamin Cole Benjamin Cole
    1. March 2014 at 22:20

    This isn’t fair but….

    THE REGIONAL ECONOMIST (St.Louis Fed) | JANUARY 2008

    Stable Prices, Stable Economy: Keeping Inflation in Check Must Be No. 1 Goal of Monetary Policymakers
    By William Poole and David C. Wheelock

    The Federal Reserve Act as amended in 1977 directs the Federal Reserve to pursue monetary policy to achieve the goals of “maximum employment, stable prices and moderate long-term interest rates.” The Federal Reserve and all central banks have also long been expected to promote financial stability. Specifically, central banks have been expected since the 19th century to serve as lender of last resort to the banking system by providing liquidity to prevent financial crises and disruptions in the payments system.

    Are the goals of maximum employment, stable prices, moderate interest rates and financial stability compatible with one another? Many people believe that they are not. Conventional wisdom holds that if monetary policy is too focused on controlling inflation, for example, then employment and output growth will likely fall below their potential, and financial markets will be less stable than they otherwise could be….

    –30–

    You think?

  13. Gravatar of Benjamin Cole Benjamin Cole
    1. March 2014 at 22:20

    This isn’t fair but….

    THE REGIONAL ECONOMIST (St.Louis Fed) | JANUARY 2008

    Stable Prices, Stable Economy: Keeping Inflation in Check Must Be No. 1 Goal of Monetary Policymakers
    By William Poole and David C. Wheelock

    The Federal Reserve Act as amended in 1977 directs the Federal Reserve to pursue monetary policy to achieve the goals of “maximum employment, stable prices and moderate long-term interest rates.” The Federal Reserve and all central banks have also long been expected to promote financial stability. Specifically, central banks have been expected since the 19th century to serve as lender of last resort to the banking system by providing liquidity to prevent financial crises and disruptions in the payments system.

    Are the goals of maximum employment, stable prices, moderate interest rates and financial stability compatible with one another? Many people believe that they are not. Conventional wisdom holds that if monetary policy is too focused on controlling inflation, for example, then employment and output growth will likely fall below their potential, and financial markets will be less stable than they otherwise could be….

    –30–

    You think?

  14. Gravatar of Bill S Bill S
    2. March 2014 at 02:37

    The fact that mistakes were made in 2008 is blindingly obvious, but where does this discussion get us? It reminds me of debates about what the Fed did or didn’t do, or should or should not have done, in 1931. A much more important question is whether the Fed did the right thing AFTER the crisis hit – both in the 1930s and over the past 5 years. My personal answer to that question is “NO”, in the 1930s, and “sort-of, but not enough” in the recent crisis. But the argument over whether Lehman (or Bear) should have been baled out in 2008 only leads to a series of counterfactuals. It’s a modern version of angels on pinheads.

  15. Gravatar of OneEyedMan OneEyedMan
    2. March 2014 at 03:40

    Almost all central banks have mandates that are at least verifiable in an internal consistency way. For example, for how many months did the Board miss both its inflation and employment targets when using their preferred measures? When it was forecasting was it symmetrically forecasting too high or too low? The comparisons on forecasts and target tracking errors seems pretty doable as a paper.

  16. Gravatar of ssumner ssumner
    2. March 2014 at 05:54

    Aidan and Travis, The problem is what they were saying in 2008.

    Mark and Ben, I agree.

  17. Gravatar of TravisV TravisV
    2. March 2014 at 10:23

    Prof. Sumner,

    Darnit, once again, you blog won’t let me link to Arnold Kling’s blog. At any rate, you should read his post entitled “Attribution to the Fed”:

    “It is quite stunning to consider Ben Bernanke’s behavior during September. On the one hand, he participated in the Paulson Panic, supporting TARP and going all out to save the banks. On the other hand he thought that the risks of inflation and recession were relatively balanced. It is consistent with my view of how the Fed looks at the world, which is through the eyes of the big NY financial institutions.

    Still, the way I see it, the attempt to attribute the Great Recession to monetary policy seems forced. The people who believe it really believe it. And I cannot tell you that it is absolutely impossible that a small change in expected inflation can send the economy down the toilet. But I think that the human bias to try to find simple, single causes for things is something to correct for here.”

  18. Gravatar of TravisV TravisV
    2. March 2014 at 10:35

    Joe Weisenthal asks:

    “Who is right about long-term unemployment: Evan Soltas or Benjamin Cole?”

    http://www.businessinsider.com/labor-market-tightness-2014-3

    http://esoltas.blogspot.com/2014/03/what-if-labor-markets-are-tight.html

  19. Gravatar of bill bill
    2. March 2014 at 10:55

    I’ve read several blog posts about the 2008 Fed transcripts and that the Fed could have saved Lehman. And how this was one of their big mistakes. We will all regret it if that becomes one of the “lessons learned”.

    Generally, I think it was right to let Lehman fail.
    That said, I think the general lack of changes in laws since then probably means that we won’t reap the benefit. In fact, since so many people think that the failure of Lehman “caused” the crisis, we may have actually made the system worse. So in a perverse way we might have been better off if Lehman was saved and we ended up with populist anger focused on our crony-infused financial system.

    By the way, when will we decide that it’s the right time to unwind Fannie and Freddie completely?

  20. Gravatar of Steve Steve
    2. March 2014 at 12:08

    Anyone want to weigh in on this graphic:

    http://research.stlouisfed.org/fredgraph.png?g=sDF

    Hint: It looks to me like the economy crashed as soon as the Fed went full-on liquidationist, and recovered as soon as the Fed reversed course.

  21. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    2. March 2014 at 12:29

    ‘By the way, when will we decide that it’s the right time to unwind Fannie and Freddie completely?’

    Ronald Reagan proposed eliminating them in 1987, so don’t hold your breath.

  22. Gravatar of Major_Freedom Major_Freedom
    2. March 2014 at 13:52

    bill:

    “I’ve read several blog posts about the 2008 Fed transcripts and that the Fed could have saved Lehman. And how this was one of their big mistakes. We will all regret it if that becomes one of the “lessons learned”.”

    The mistake was bailing out other firms, not failing to bail out Lehman.

  23. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2014 at 15:46

    Scott,
    Off Topic.

    Robert Shiller argues that the unit of account function may give a better justification for electronic money than medium of account, or store of value:

    http://www.nytimes.com/2014/03/02/business/in-search-of-a-stable-electronic-currency.html

    “…But if we go back to the electronic-money drawing board, we may conclude that Bitcoin has been focused on the wrong classical functions of money, as a medium of exchange and a store of value. Bitcoin offers a way of “mining” electronic coins that can replace our dollar bills and bank accounts. Yet there is no fundamental need for this. Money, as we’ve known it for decades, works quite well in these respects. It would be much better to focus on another classical function: money as a unit of account — that is, as a basic standard of economic measurement. Scientists spend a lot of time thinking about ways to improve systems of measurement. Business people should, too…”

    He also mentions trills (once again):

    “…And there could be a “trills” unit — a concept that Mark Kamstra of York University and I have been advocating — that represents one trillionth of a country’s most recently estimated annual [NGDP]…”

  24. Gravatar of Mark A. Sadowski Mark A. Sadowski
    2. March 2014 at 15:58

    Scott,
    Off Topic.

    Yanis Varoufakis looks at the state of the Greek economy in nominal terms.

    http://yanisvaroufakis.eu/2014/03/01/what-you-should-know-about-greeces-present-state-of-affairs-an-update/

    “…According to the government and the troika, 2013 was the year the recession decelerated. It did no such thing. While it is true that, in real terms, the rate of shrinkage declined (see following diagram), the reality is less heroic.

    [Graph]

    If we look at nominal GDP, a far more poignant statistic than real GDP in times of recession,[i] we shall be horrified to discover that the recession picked up speed in 2013, compared to the abysmal years 2012, 2011 and 2010. Indeed, as you can see from the figures below, whereas nominal GDP fell from 2011 to 2012 by a modest 1.1%, between 2012 and 2013 it shrank by a walloping 14%! In this sense, the Greek economy’s performance in 2013 was even worse than that of 2010 and 2011 – the first two years after Greece’s implosion.

    Year Nominal Annual GDP ‘Growth
    2010 (-7.5%)
    2011 (-8.9%)
    2012 (-1.1%)
    2013 (-14%)
    2009-13 (-27.08%)…”

    He explains in a footnote why NGDP is better than RGDP for this purpose:

    “…[i] It is so for two reasons: First, during recessions the GDP deflator overestimates the price drops that affect the majority of people. Secondly, in an economy with gigantic debt (private and public) overhang, nominal output and income is crucial, since the nominal value of the debts remain constant. The diagram below confirms, for those that have no seen it before, that Greece is in the clasps of deflation…”

    He also mentions the following interesting superlative:

    “…Have you heard the news? Greece is now a surplus nation! At least in current account terms. Is this not good news? If it were due to a significant rise in exports, and some strong import substitution (with domestically produced goods and services edging imported competitors out), it would have been good news. Only this was not the reason Greece has a current account surplus today. The sorry reason for this surplus is that the deepening recession shrunk imports by a further 11% while tourist income last summer rose a little as Turkey’s and Egypt’s political troubles diverted tourists to Greece’s shores. What about exports? I am afraid that they were lower in 2013 than they were in 2011, when they were much lower than in… 2008.

    Still, the news media were only too quick to hail the miracle of a Greek current account surplus. Foolish as they tend to be, they added that “Greece has not posted a current account surplus for many decades.” That’s quite so. What they, however, failed to add is the year when Greece’s current account was positive last. Let me reveal it for you: It was 1943 – under the Nazi occupation, when Greeks could not afford to eat (let alone import goods from abroad) but still managed to export a few oranges, a few apples etc. Today, once more, the collapse of domestic demand, even in the absence of an export drive (due to the lack of credit to export-oriented businesses), has produced a 1943-like situation. Not a cause for celebration; at least not in my book…”

  25. Gravatar of benjamin cole benjamin cole
    2. March 2014 at 16:43

    Bill and Pat: Fannie and Freddie die the same the homeowner mortgage interest tax deduction does…

  26. Gravatar of Matt Waters Matt Waters
    3. March 2014 at 00:22

    Reading this piece, I had forgotten who Bullard was exactly, googled him and found this presentation:

    http://research.stlouisfed.org/econ/bullard/pdf/Bullard_NWArkansas_2013November21_Final.pdf

    I am particularly aghast at slides 33-34 near the end of it, on the “zero lower bound.”

    “The debate over the wisdom of locking in near-zero rates did not take sufficient account of the experience in Japan, in my view.”

    “The BOJ changed the policy rate to near zero in the 1990s.
    Short-term rates remain at zero today in Japan, 15 years later”

    “Some analysis suggests that the sooner policymakers set the
    policy rate to zero, the sooner the economy will recover and the sooner interest rates can be returned to normal.”

    “I have seen no evidence that this is true during the last five years.”

    “Instead, I think the December 2008 FOMC decision unwittingly
    committed the U.S. to an extremely long period at the zero lower bound similar to the situation in Japan, with unknown
    consequences for the macroeconomy.”

    I know I’ve heard murmurs of criticism of zero-interest rates, and maybe I glazed over where a FOMC member has said that before, but this is the first time I have starkly seen such poor economics from an FOMC member, and I have seen many of Fisher’s and Plosser’s statements before. Saying that zero interest rates are ineffective is fine and in fact true if expectations don’t go hand-in-hand. Reducing costs of funds by a percent or two, in and of itself without expectations, won’t set the economy on fire. But the fact that Bullard apparently thinks zero rates CAUSED the Japanese lost decade and not the other way around, I am quite honestly speechless.

  27. Gravatar of Michael Byrnes Michael Byrnes
    3. March 2014 at 03:44

    Off-topic – Paul Krugman seems to come around to one drum you have been beating for quite some time:

    “I still think that a fall in g leads to a fall in r (as it did in Japan), so that the budgetary implications are weaker than CBO seems to think. But lower growth does appear to make debt harder, not easier, to carry.”

    http://krugman.blogs.nytimes.com/2014/03/02/growth-and-interest-rates-i-appear-to-be-wrong/?module=BlogPost-Title&version=Blog%20Main&contentCollection=Opinion&action=Click&pgtype=Blogs&region=Body

  28. Gravatar of J Mann J Mann
    3. March 2014 at 08:56

    1) I don’t know that counting the words “inflation” vs “crisis” is necessarily informative. I guess it is if you are confident that no one is saying “inflation is actually too low” or “we need more inflation,” but then you’re begging the question by just including the raw count.

    2) “We should have saved Lehman” is a big leap. I remember the discussions back then, and pretty much nobody liked the idea that creditors of Lehman and Bear should assume they were de facto insured by the Fed. Is the new wisdom that they necessarily had to be? (I’m a lot more comfortable with “we should have ordered some more inflation.”)

  29. Gravatar of flow5 flow5
    5. March 2014 at 09:51

    “the notion that excessively tight money was the problem was almost laughed off the stage”

    Remember that St. Louis Fed’s technical staff surmised: “Although the evidence is mixed, the MSI (monetary services index), overall suggest that monetary policy WAS ACCOMMODATIVE before the financial crisis when judged in terms of liquidity. —Richard G. Anderson & Barry Jones.

    NOT SO. The roc’s in MVt (in Dec 2007) undeniably pointed to a recession beginning in the 4th qtr of 2008.

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