When I stated blogging in early 2009, people were incredulous when I blamed the recession on tight money.  Most people thought it was “obvious” that the recession was caused by the house price bubble.  (There was no housing construction bubble–Kevin Erdmann has lots of research showing that housing construction during the 2000s was at normal levels.)

OK, if was obvious that home prices were wildly excessive in 2006, why is that not also true today?  Nominal house prices are now far above 2006 levels, and even in real terms they are rapidly approaching the 2006 peak, as this graph shows (deflating by the PCE index):

So let’s see what these pundits say today.  Are they calling for investors to engage in “the big short”, as John Paulson did in 2008?  Are they predicting another Great Recession?  Are they predicting another crash in housing prices?  Are they predicting another banking crisis?  If not, why not?

Is it possible that the housing boom was not a bubble?  Is it possible that fundamentals (such as building restrictions and lower real interest rates) support much higher real housing prices during the 21st century than during the 20th century?  Is it possible that the real problem was nominal, a fall in NGDP engineered by a monetary policy that (during 2008) held the Fed’s target interest rate far above the equilibrium interest rates?  Is that why unemployment stayed low as housing construction fell in half between January 2006 and April 2008, and then soared when tight money pushed NGDP down in late 2008?

Lots of pundits were saying housing prices were excessive as far back as 2003; when even in real terms they were far lower than today.  Do these same pundits again predict a collapse?  If not, why not?

It’s rare that life gives us a second chance to test a theory.  Let’s not waste it; let’s follow this experiment quite closely over the next few years.  I plan to, and I’ll keep reminding people of the outcome.

Back in 2008, it seems like everyone from the Queen of England on down was blaming economists for not predicting the financial crisis.  I seem to recall that Bob Lucas pointed out that economic theory explains why economists cannot predict financial crises, so our failure to do so was a feather in the cap of modern economic theory.  I also seem to recall that lots of people rolled their eyes at his seemingly too clever excuse.

In the past I’ve argued that Lucas was exactly right, but in this post I’ll assume he was wrong.  I’ll assume the EMH is wrong.  Even in that case I’m going to argue the complaints were silly, just a bunch of crybabies.

So how do I respond to those people who are moaning that we didn’t warn them that a crisis was coming?  One answer is that some economists, such as Nouriel Roubini, did issue warnings.  But then the crybabies might respond, “But most economists didn’t warn us.  How were we to know that he was the one to listen to? The economics profession as a whole should have issued a warning, so that it was unambiguously clear to the public that a financial crisis was coming.”

To summarize, a few economists did warn the public, so the crybabies’ lament only makes sense if you assume that these people wanted the profession as a whole to offer a clear credible warning to the public.  Something that would be believed.

Were you the sort of person who believed in Santa Claus, and thought he would bring you a fairytale castle floating on a cloud, with unicorns prancing about in front?  If not, why would you make such a patently unrealistic demand of the economics profession?

You wanted us to warn you that a big financial crisis was coming so that you could sell all your stocks before they went down?  I ask this because a prediction of a severe financial crisis is implicitly also a prediction of a massive asset price collapse.  So the people complaining that economists didn’t predict the financial crisis are (whether they know this or not) effectively complaining that economists didn’t warn them that their 401k plan was about to lose a few hundred thousand dollars.

Let’s suppose we have a time machine and economists from October 2008 can go back 6 months in time, to April 2008.  They are told to warn the public that a massive financial crisis is coming in the fall.  They warn the public that Lehman won’t be bailed out, and its failure will trigger a rush for liquidity and a Great Recession.  What exactly would that warning have done, other than move those events up 6 months in time?  Then the crybabies would have asked why we didn’t warn them in October 2007 (assuming they didn’t lynch the economists for causing the crash.)

And as for those stocks you were going to sell if economists had warned you of the crash—just who did you plan to sell them to?  And at what price?

A better argument is that the economics profession didn’t warn the public that public policy was creating excessive lending, as Fannie and Freddie and FDIC and TBTF were creating moral hazard.  In fact, I did warn people I met about this problem (but I completely failed to forecast the financial crisis.)  Some other economists also warned about moral hazard, but not all.  But no one wants to listen to a bunch of killjoy economists on public policy questions.  It would be like blaming economists for tariffs, or rent controls.

When I explain to non-economist commenters what economic theory tells us about some public policy, they almost universally blow off my advice, unless it coincides with their pre-existing view on that particular public policy.  No one cares what economists think, so don’t blame us for areas where we have no control.  (Monetary policy is a different case; there the economics profession actually deserves far more blame than it’s gotten from the public.)

PS.  I see that Trump threw a temper tantrum when his aides told him that Iran had been adhering to the nuclear agreement.  We now have an administration with no ability to negotiate because no one trusts them to keep their word.  The focus of his top aides is not dealing with foreign crises but rather managing unnecessary crises created by an out of control and mentally ill president.  North Korea knows we’ll renege on any agreement we sign with them, and so a nuclear deterrent is their only option.  Meanwhile they show their population images of Trump threatening to destroy their country.

Meanwhile Trump has abandoned the utilitarian approach of the Obama administration and the slaughter of innocent civilians has been skyrocketing:

Airwars reports that under Obama’s leadership, the fight against ISIS led to approximately 2,300 to 3,400 civilian deaths. Through the first seven months of the Trump administration, they estimate that coalition air strikes have killed between 2,800 and 4,500 civilians.

Trump seems like excellent black comedy to me, but unfortunately there are lots of dead women and children for whom he is no joke.

PPS:  New Flash:  Americans horrified to discover Hollywood producer behaving like a President of the United States.  Hillary and Fox News particularly disgusted by this behavior.

PPPS:  Another gem:

Speaking over the phone, Mr Reich said he asked his friend whether other Republican senators were preparing to follow Senator Bob Corker and “call it quits with Trump”.

His source told him: “Others are thinking about doing what Bob did. Sounding the alarm. They think Trump’s nuts. Unfit. Dangerous.” . . .

“Tillerson would leave tomorrow if he wasn’t so worried Trump would go nuclear, literally,” he added.

“Who knows what’s in his head? But I can tell you this. He’s not listening to anyone. Not a soul.

“He’s got the nuclear codes and, well, it scares the hell out of me. It’s starting to scare all of them. That’s really why Bob spoke up.”

Trump ran for President as a crazy man, and we are shocked to discover he is governing as a crazy man?

Caroline Baum has an interesting article on a new book written by DiMartino Booth, who worked at the Fed from 2006 to (I think) 2015:

The Fed regularly publishes a summary of economic conditions in the 12 federal reserve districts, but when real-world information contradicts the Fed’s econometric model, the model wins. DiMartino Booth provided Fisher with real-time information — not seasonally adjusted, to the consternation of the staff — gleaned from an array of market sources and data sets.

Fisher, with his background in business, finance and government, earned a reputation as a maverick inside the Fed. He dissented from the FOMC statement five times in 2008, twice in 2011 and twice again in 2014, in all cases favoring less monetary accommodation or earlier rate hikes than the consensus view.

Fisher retired at the end of 2014; DiMartino Booth followed shortly after, once she realized her real “mission” is to educate the public about the inner workings of the Fed. “Fed Up” succeeds in doing just that. . . .

One of her suggestions made me laugh out loud. The Fed should ship the Ph.D. economists back to academia and use the money saved to hire some crack bank supervisors at competitive salaries for the Fed’s “Sup & Reg departments,” traditionally a second-tier job at the Fed.

A few comments:

1.  In retrospect, it’s clear that all of the Fisher votes cited above were in error. Indeed in my view that’s not even debatable.  The fact that it is debated tells us that we need to reform Fed policy is such a way that clearly mistaken votes are no longer debatable.  Chad Reese and I have a letter just published in The Hill that discusses this issue.

2.  You generally don’t want to rely on non-seasonally adjusted data, which might signal a huge “boom” in December.

3.  Over the past three decades, the Fed has relied far more heavily on academic economists than in the past.  During this period, Fed policy has become vastly more stable than in the prior 70 years, whether you rely on inflation or NGDP growth as your indicator.

The author advocates greater diversity at the Fed: specifically, more staffers with actual business experience and fewer ivory-tower types. She would like to see an increased focus on systemic risk. And she wants Congress to release the Fed from its dual mandate — stable prices and maximum employment — so it can focus solely on price stability. . . .

Where I [Caroline Baum] would challenge DiMartino Booth is on her recommendation that the Fed normalize the overnight rate and pledge never to breach the 2% floor again so as not to punish savers.

I have not read her book and I may be misinterpreting the comment about a 2% floor.  But if the floor refers to interest rates, then I’d say the proposal is either absolutely horrible or mindbogglingly insane.  Let’s start with the best case, absolutely horrible:

1.  One way to make sure interest rates never again fell below 2% is to raise the inflation target to 10%.  That’s a horrible idea, and since it would probably punish savers I don’t think that’s what the quote refers to.

2.  If the inflation target is kept at 2%, then a 2% interest rate floor would be non-credible, because it would be impossible for the Fed to achieve.  But trying to achieve it could easily cause another Great Depression.  A mindbogglingly bad idea. This is why you don’t want non-PhDs making monetary policy.  Indeed, even the brief April to October 2008 2% interest rate floor proved to be disastrous.

PS.  Vaidas Urba sent me another post that comments on the same book.  Looks like a very good blog.

PPS.  The case for the Fed increasing its interest rate target is growing stronger by the day.  Some of the new data looks quite strong for both prices and output. Continued talk of fiscal stimulus is starting to look kind of silly.  For the first time since I started blogging, I see the monetary policy risks as being balanced, instead of skewed to the downside.

PPPS.   Many commenters are unaware of my current views on NGDP targeting.  I currently favor the “guardrails” approach, which is not susceptible to the market manipulation problem.  Nor would lack of trading be a problem.  My attempt to create a small NGDP prediction market is not to be confused with this policy proposal.  I have a new article in the Journal of Macroeconomics that explains my current views on a wide range of monetary policy rule issues.

PPPPS.  A zero percent interest rate floor would be less bad than 2%, as the Fed has the option of QE.

PPPPPS.  For those who don’t have access to the JM article, the basic idea is as follows.  The Fed sets a 4% NGDP target path, level targeting.  If the economy is currently on target, the Fed commits to take a short position against any NGDP futures trader going long at 5% NGDP growth, and the Fed takes a long position on any NGDP futures traders who go short at 3% NGDP growth.  Thus the Fed might be exposed to loses if the actual NGDP growth rate is outside the 3% to 5% guardrails.  The losses could be large if, ex ante, it’s clear to traders that NGDP growth will be far too high, or too low.

The Fed monitors the trades.  It still has 100% discretion over monetary policy, with the proviso that it be willing to commit to the NGDP positions described above. This is much like Bretton Woods or a gold standard (where they committed to exchange money for gold, instead of NGDP contracts), and no more susceptible to market manipulation than those regimes.  Indeed less so, as the “band” is (effectively) wider than under the gold standard. The Fed can and should ignore a single large trader, who might be engaged in market manipulation.  If it sees lots of traders all going long or short, and if the Fed’s potential losses become too large, it may want to take corrective action.

Even if I were wrong about manipulation, competition among potential manipulators would keep expected NGDP growth in the 3% to 5% range (as the second manipulator could offset the first, and earn larger profits by going the opposite direction).

Here’s another metaphor.  The 3% and 5% guardrails serve the same purpose as the beeping sound when trucks are backing up, and get too close to hitting something.

The basic idea here is to allow me, Scott Sumner, to get filthy rich if the Fed screws up the way they did in 2008.  Since I’m a fatalist who never expects to get filthy rich, I would not expect the Fed to screw up under my proposed guardrails regime. I hope I’m wrong!!

I.e. the regulatory structure that gave us the mid-2007 to mid-2008 banking crisis (the late 2008 crisis was also on the Fed.)

That’s what I infer from this letter sent to the Fed from an important GOP Congressman.

I have been a big critic of Dodd-Frank and wouldn’t mind seeing it repealed.  But only if other simpler and more effective regulatory changes are made.  Those might include higher bank capital requirements, getting rid of Fannie and Freddie, and/or reforming FDIC.  But as far as I can tell, the GOP is opposed to all of these actions.  Indeed the letter warns that higher capital requirements will slow economic growth.

So it looks to me like the GOP favors the regulatory system that led to the 1980s banking crisis and the 2007 banking crisis.  Am I wrong?  (I hope so.)

PS.  The letter is hard to quote from, as it’s a photo that’s difficult to copy.  But the gist of Congressman Patrick McHenry’s letter is, “Give banks liberty, or give me death.”

HT Lars Christensen

Update:  You heard it here first.  Trump will replace Mike Pence with Noam Chomsky in 2020—a better fit for his views:

When Fox News’s Bill O’Reilly challenged Mr Trump in the interview, saying “Putin’s a killer,” the president replied: “There are a lot of killers. We have a lot of killers . . . What, you think our country is so innocent?”  .  .  . ” I do respect him [Putin].”

How many times have top GOP figures had to totally disavow the embarrassing statements made by Trump over the past 12 months?

David Beckworth was interviewed by Russ Roberts this morning in a special video version of EconTalk, which was held at the Cato Institute and hosted by George Selgin. Unfortunately I am not able to find a link for the talk, but I’ll put one up if someone else can direct me to it.

Update:  Here’s the link:

http://www.cato.org/events/econtalk-live-david-beckworth-monetary-policy-great-recession

Update#2:  I’m told the link no longer works, but a new link should be up in about 10 days.

There was some discussion of whether the market monetarist critique of Fed policy in 2008 is just Monday morning quarterbacking.  David seemed to concede that this complaint had some merit, and perhaps to some extent it does.  But I also think David is being too modest.  Here’s David criticizing interest on reserves, way back in October 2008, right after it was first adopted:

Is the Federal Reserve (Fed) making a similar mistake to the one it made in 1936-1937? If you recall, the Fed during this time doubled the required reserve ratio under the mistaken belief that it would reign in what appeared to be an inordinate buildup of excess reserves. The Fed was concerned these funds could lead to excessive credit growth in the future and decided to act preemptively. What the Fed failed to consider was that the unusually large buildup of excess reserves was the result of banks insuring themselves against a replay of the 1930-1933 banking panics. So when the Fed increased the reserve requirements, the banks responded by cutting down on loans to maintain their precautionary level of excess reserves. As a result, the money multiplier dropped and the money supply growth stalled as seen in the figure below.

.  .  .

Now in 2008 the Fed did not suddenly increased reserve requirements, but it did just start paying interest on excess reserves. The Fed, then, just as it did in 1936-1937 has increased the incentive for banks to hold more excess reserves. As a result, there has been a similar decline in the money multiplier and the broader money supply (as measured by MZM) which I documented yesterday. If the Fed’s goal is to stabilize the economy, then this policy move appears as counterproductive as was the reserve requirement increase in 1936-1937.

David says that in retrospect he thinks that Fed policy went off course even earlier, in the middle of 2008. Speaking for myself, I didn’t really become aware of the problems with monetary policy until September 2008, after the Fed refused to cut rates despite plunging TIPS spreads.  In retrospect, money became much too tight a couple of months earlier.

Because of data lags, it’s not always possible to predict a recession until the recession is already well underway.  During the past three recessions, a consensus of economists didn’t predict a recession until about 6 months in.  That’s right, not only are macroeconomists unable to forecast, we are also unable to nowcast.

This is why NGDPLT is so important. Under a level targeting regime, the market tends to prevent sharp drops in NGDP from occurring in the first place.  Under NGDPLT, the economy would not have fallen as sharply in late 2008, partly because level targeting would have prevented a steep plunge in asset prices, and partly because current AD is heavily dependent on future expected AD.  If you keep future expected AD rising along a 5% growth path, current AD will not fall very far during a banking crisis.

There was also some discussion of the shortage of safe assets.  Two questions came to mind:

1.  Does this theory imply that risk spreads should have widened in recent years, as the demand for T-bonds has increased faster than the demand for riskier bonds?

2.  Has this in fact occurred, and if so to what extent?