Archive for the Category Crisis of 2008


One shock to rule them all

Marcus Nunes directs me to a new Brad DeLong post, discussing six big shocks that have hit the US economy since 2005. But I agree with Marcus, I only see one. First let’s look at DeLong’s six:

(1) The collapse of residential investment after the end of the mid-2000s housing bubble, in order of their size (-3.8% of potential GDP):

(2) The wave of austerity–mostly state-and-local, but considerable at the federal level as well–hitting government purchases (-3.0% of potential GDP):

(3) The collapse of business fixed investment in the aftermath of the financial crisis (-2.9% of potential GDP):

(4) The blockage of the credit channel that prevented there from being much significant bounce-back to normal in residential construction (-1.8% of potential GDP):

(5) The (closely-associated with (3)) collapse of exports as the effects of the financial crisis spread beyond U.S. borders (-1.8% of potential GDP):

And (6) on a different graph (since it is not one of the four salient components), and also closely-associated with (3), the adverse shock to consumption as it became clear first that there was going to be a deep and then a long downturn (-1.8% of potential GDP):

All I see is a big monetary shock; a tight money policy in 2008 that caused NGDP to fall during 2008-09 at the steepest rate since the 1930s.

1.  Residential construction fell more than in half between January 2006 and April 2008, but unemployment merely edged up from 4.7% to 5.0%, and the consensus view of economists was that 2009 would be an OK year.  Yes, 2009 turned out not to be an OK year, but that wasn’t because of a housing collapse that economists were already well aware of, but rather because of a NGDP collapse that they did not predict, even in April 2008.

2.  What austerity?  Has government spending fallen as a share of GDP?   Yes, it’s slowed relative to trend, as you’d expect in a economy that has slowed relative to trend.  Sorry, but living within your means is not a “shock.”

3.  Yes, investment is highly cyclical, and falls sharply in deep recessions caused by too little NGDP.  It’s the effect of a shock.

4.  OK, this is an independent shock, but we’ve already seen that housing is no big deal.  With adequate NGDP growth the labor market would have been fine.

5.  Yes, money was also tight in Europe and Japan.

6.  Even DeLong admits the fall in consumption is an endogenous response to the deep recession.

Please don’t misinterpret this post.  The world is very complex.  The causes of the NGDP shock were very complex.  Perhaps all six items mentioned by DeLong played some indirect role in monetary policy going off course.  But the sooner we start thinking in terms of 2008-09 being a single shock, the sooner we’ll demand more from our central banks, and the sooner we’ll get better monetary policy.

Regardless of whether I am right or DeLong is right, it’s very much in America’s interest if the Fed believes that I am right.

PS.  DeLong ends as follows:

And they say: given those six shocks and their magnitude, haven’t we done rather well at stabilizing the economy? Haven’t we certainly done much better than the BoJ, or the ECB, or the Bank of England?

And they are right: they have.

Since late 2008, the Federal Reserve has a lot to be proud of.

I’m not so sure of that.  The US has faster population growth than Japan, and faster productivity growth than Britain, but haven’t their labor markets done much better, in the sense that employment population ratios are soaring to new highs, while ours languishes?  (I’m relying on memory here due to a hectic holiday schedule, correct me if I’m wrong.)

But yes, much, much, much better than the brain dead ECB.

Merry Christmas, and check out my Econlog post.


Hindsight is 20-20 (at best)

Update:  I see Matt Yglesias beat me to it.

Before criticizing a Paul Krugman post let me praise his recent post on the Chinese yuan.  I completely agree that the press is overplaying the IMF’s decision to make it a reserve currency.  I did see one report that this might push the Chinese to do more financial reforms, which would be fine.  But countries don’t benefit from reserve currency status anywhere near as much as the media would lead you to believe.

In an earlier post Krugman unintentionally insults Dean Baker:

It’s true that Greenspan and others were busy denying the very possibility of a housing bubble. And it’s also true that anyone suggesting that such a bubble existed was attacked furiously — “You’re only saying that because you hate Bush!” Still, there were a number of economic analysts making the case for a massive bubble. Here’s Dean Baker in 2002. Bill McBride (Calculated Risk) was on the case early and very effectively. I keyed off Baker and McBride, arguing for a bubble in 2004 and making my big statement about the analytics in 2005, that is, if anything a bit earlier than most of the events in the film. I’m still fairly proud of that piece, by the way, because I think I got it very right by emphasizing the importance of breaking apart regional trends.

So the bubble itself was something number crunchers could see without delving into the details of MBS, traveling around Florida, or any of the other drama shown in the film. In fact, I’d say that the housing bubble of the mid-2000s was the most obvious thing I’ve ever seen, and that the refusal of so many people to acknowledge the possibility was a dramatic illustration of motivated reasoning at work.

I hear this claim over and over again, and just don’t understand it.  First let’s consider the Baker claim that 2002 was a bubble.  As the following graph shows, US housing prices are higher than in 2002, even adjusted for inflation.  In nominal terms they are much higher.  So the 2002 bubble claim turned out to be completely incorrect. Krugman needs to stop mentioning Baker’s 2002 prediction, which I’m sure Baker would just as soon forget.

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Of course prices then rose much higher, and are still somewhat lower that the 2006 peak, especially when adjusting for inflation. So I can see how someone might claim that 2006 was a bubble (although I don’t agree, because I don’t think bubbles exist.)

But here’s what I don’t get.  Krugman says it was one of the “most obvious” things he’d ever seen.  That’s really odd.  I looked at the other developed countries that had similar price run-ups, and found 11.  Of those 6 stayed up at “bubble” levels and 5 came back down.  If they still reported New Zealand it would have been 7 to 5 against Krugman. How can you claim something is completely obvious, when there is less than a 50-50 chance you will be correct?  If Krugman were British or Canadian he would have been wrong.

But it gets worse.  Almost no one, not even Krugman, thought we’d have a Great Recession. That makes the bubble claim even more dubious.  Does anyone seriously believe that the utter collapse of the Greek economy has nothing to do with the decline in Greek house prices?  That it’s all about bubbles bursting, with no fundamental factors at all?  That seems to be the claim of the bubble mongers. Even in the US, at least a part of the decline was due to the weak economy.  No, I’m not claiming all of it, but at least a portion.  Look at France, which held up pretty well despite a double-dip recession.  You can clearly see the double dip in the French house prices, so no one can tell me that macroeconomic shocks like bad recessions don’t affect house prices.

In conclusion, even ignoring the elephant in the room–the Great Recession–Krugman’s claim that a bubble was obvious makes no sense.  Most housing markets didn’t collapse after similar run ups.  Most are still up near the peak levels of 2006, even adjusted for inflation (and significantly higher in nominal terms.)  But add in the Great Recession, and the bubble claim becomes far weaker.

Of all the cognitive illusions in economics, bubbles are one of the most seductive. But I expect more from an economist who usually sees through these cognitive illusions, and did a good job showing the fallacy of the claim that reserve currencies status has great benefits to an economy.

PS.  In case you have trouble reading the graphs, the 5 countries with big drops are the US, Greece, Italy, Spain and Ireland.  The US drop is even more surprising when you consider that our post-2006 macro performance is more like the 6 winners.  So I could have claimed it was 6 to 1 against Krugman, if I’d put in a dummy variable for “PIIGS” status.  Does any bubble-monger know why Australian, British, Belgian, Canadian, French, New Zealand, and Swedish house prices are still close to the same lofty levels as 2006, or even higher?  What’s different about the US that made a collapse “inevitable”?

(Paging Kevin Erdmann.)

PS.  I also have a post on Krugman over at Econlog, in case you haven’t gotten your fill here.

Nominal shocks have real effects

Michael Darda sent me a graph that provides another good example of how nominal shocks have real effects.  The graph compares the spread between Baa bond yields and T-bond yields (white line) with an inverted measure of 30 years TIPS spreads (orange line).  The TIPS spreads are inverted because the BAA/Treasury spread is a countercyclical variable, whereas TIPS spreads are procyclical:

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I really love this graph, because it shows an underlying relationship that many people over look.  Always focus on the deep forces driving the macroeconomy, not the symptoms of those deep forces.

So here’s what’s going on.  Tight money leads to lower expected future NGDP growth.  I don’t think that can be disputed.  And I’d also claim that slower expected NGDP growth usually leads to lower TIPS spreads.  In addition, slower nominal GDP growth usually leads to increased fears of debt defaults.  Recall that NGDP represents total gross nominal income, the total resources that people, businesses and governments have available to repay nominal debts.  Squeeze that amount and defaults increase.

When NGDP grows more slowly, TIPS spreads fall and debt defaults increase.  That is even true in an economy where wages and prices are flexible, but debt is denominated in nominal terms.  But it’s even worse in the actual economy we live in, where wages are sticky.  In that case slower NGDP growth also leads to lower RGDP growth, which puts even more pressure on borrowers, leading to even more defaults.  Hence the Baa/Treasury spread widens.  And note that the Baa/Treasury spread is a real variable. Hence nominal shocks have real effects.

Of course the correlation is not perfect because TIPS spreads aren’t really the variable we care about, it’s NGDP expectations that really matter.  Notice the gap in the first half of the recession (roughly the first half of 2008.)  That was a period where inflation diverged sharply from NGDP growth.  Money was tighter than the inflation numbers suggested.

Don’t tell me the facts, I’ve already made up my mind

On some days that’s my impression of the economics profession.  They’ve made up their minds that the financial crisis (not tight money) caused the recession.  When I point to the huge decline in NGDP growth, they insist that’s not monetary policy. They say, “It was a fall in velocity, not tight money.”  And yet that’s not true, base velocity was actually rising as the Fed drove the economy into recession.  As you can see from the following graph, the Fed gradually squeezed growth in the monetary base, until by early 2008 the year-over-year percentage growth rate of the base had fallen to about 1%.  This gradually squeezed year over year NGDP growth, which slowed to 2% by mid-2008 (and much worse later on.)

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Just to be clear, I’m not suggesting the monetary base is a good way of thinking about the stance of monetary policy, it’s not.  I’m just pointing out that the “concrete steppes” people who insist it’s not the Fed’s fault if V falls, only if the Fed does something concrete with the base, themselves never bother to look for concrete steps.  If you tell them that the onset of the recession can easily be accounted for by this concrete action, they’ll still deny the Fed caused the recession. They’ve already made up their minds. Facts simply don’t matter.

Others will insist that monetary policy is all about interest rates. If you ask “real or nominal” they’ll say real rates.  Real rates did fall in the early stages of the recession, as is often the case, but then something really weird happened.  Real yields on 5 year TIPS soared between the spring and fall of 2008, as unemployment began to rise sharply.  If you point this out, they’ll still deny there was any tight money, because they’ve made up their minds that tight money could not possibly be to blame.

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The economics profession considers the Fed to be sort of like the Pope, basically infallible, except for tiny errors induced by data lags.  Any shock to AD can’t possible be caused by the Fed, because they fix problems, they don’t cause problems.  Here’s James Alexander, posing a question to Tony Yates:

I think Yates’ course might be interesting but would it really help me with my questions.. The blogsphere is alive with debate on them and sometimes academic papers are referred to, but most seem unsatisfactory in one way or another.

Anyway, would they help answer this question: Would you ever create a model that included occasional, but deeply random tightening and loosening of monetary policy by central banks?

To this one he [Yates] answered: “Yes, if you thought central banks faced measurement error in real time, or changes in committee membership that meant changes in the preferences of the median committee voter. Have a look. Large literature on just that.”

I think Yates is expressing the mainstream view.  We can draw an AS/AD diagram, and ask our students what would happen to AD if there were an expansionary or contractionary monetary shock.  But deep down the profession doesn’t believe those shocks are important.  Rather they think there are non-monetary AD shocks, which central banks offset with more or less skill.  But surely central banks wouldn’t just create a negative AD shock out of thin air?  The ECB wouldn’t just suddenly raise interest rates in July 2008, or April 2011, would they?  Bueller, are you paying attention?

This faith in central bankers is what I reject.  I see no reason at all to assume that 2007-09 was not a massive negative AD shock, caused by a series of central bank errors of commission and omission.  These occur due to a complex mixture of data lag problems (correctly identified by Yates), ignoring market signals, and a deeply flawed model of monetary economics that focuses on growth rates, not levels.  All three flaws came together in 2008.  First the economy began to slump.  That’s the data lag.  Then the markets recognized the problem, but the Fed still did not. That’s ignoring market signals (i.e. Sept. 2008).  Then when even the Fed realized the problem, they refused to commit to bring NGDP (or even the price level) back up to the previous 5% (or 2%) trend line.  Put these three together and you get a massive negative monetary shock and the Great Recession.

PS.  I was recently interviewed by the Frankfurter Allgemeine.  Here is an excerpt:

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The article is gated, and costs 2 euros.  (Most of the article discusses Larry Summers, not me.)

The smiling assassin

Picture a crime movie where the killer is arrested.  After hours of being grilled under a hot incandescent bulb, he breaks down and confesses, sobbing as he describes how he murdered his wife so he could get the insurance money and run off with a another woman.  It would be very odd if the killer calmly confessed to that crime, with the demeanor of someone describing a walk in the park, or taking the kids out to fly a kite. You expect remorse. Indeed a calm demeanor might be taken as evidence of insanity; maybe the killer didn’t even understand what he had done.

Let’s set the stage.  It’s early October 2008.  It’s been three weeks since Lehman failed, and the global economy is starting to fall apart.  There are scary stories about trade plunging all over the world.  The stock market is crashing, falling continuously during the first 10 days of October, often by large amounts.  TIPS spreads are plunging. Commodity prices are plunging.  Commercial real estate is beginning to fall sharply, after surviving the initial subprime crisis.  Unemployment is rising sharply.  What does the Fed decide to do?  Commenter Beefcake sent me to the San Francisco Fed, for its explanation.

Before the crisis, Congress passed the Financial Services Regulatory Relief Act of 2006 authorizing the Federal Reserve to begin paying interest on reserves held against certain types of deposit liabilities. The legislation was supposed to go into effect beginning October 1, 2011. However, during the financial crisis, the effective date was moved up by three years through the Emergency Economic Stabilization Act of 2008.4 This was important for monetary policy because the Federal Reserve’s various liquidity facilities5 initiated during the financial crisis caused upward pressure on excess reserves and placed downward pressure on the Federal funds rate. To counteract these pressures, on October 6, 2008, the Federal Reserve Board announced that it would begin paying interest on depository institutions’ reserve balances.

Well there you are, what could be more sensible?  I’m impressed at the audacity of the Fed, if nothing else.  This is the explanation they provide in their “education” department.  I suppose the average man on the street would nod his head, thinking, “It sure looks like the Fed knew what they were doing.”

There’s just one problem, the Fed is describing a murder, the killing of the economy. Don’t be fooled by the calm tone of this explanation.  They are describing a policy that they themselves indicate was rushed into service three years early in order to prevent interest rates from falling.  Its entire purpose was to prevent monetary stimulus, to make money tighter.

Their explanation is that the money that was being put into the banking system to rescue Wall Street threatened to also reduce interest rates thus easing monetary policy. But that could have the side effect of also rescuing Main Street!  The Fed was so horrified by the thought of a cut in interest rates at the time the economy was falling off a cliff that they begged Congress to let them move earlier on IOR.

You might wonder why the Fed simply didn’t wave its magic wand, and set rates where they wanted them.  Actually, before they had the legal option of doing IOR, the Fed had no magic wand. It only seemed like they could directly control interest rates.  In fact, they controlled the monetary base, and used changes in the base to influence interest rates.  When they sharply boosted the base to rescue the banks in September 2008, they had no way of stopping interest rates from falling all the way to zero.

The week this happened I went absolutely ballistic, and essentially became a different person.  (After not have a strong opinion on monetary policy for the previous 25 years) I went down to Harvard to ask the top macroeconomists what the hell the Fed was doing, something I never would have done before 2008.

Now inevitably someone will cite Paul Krugman, who likes to point out that central banks are quite capable of driving the economy into a zero rate trap without IOR. The Japanese did it in the 1990s, and the Fed did it in the 1930s. That’s true but irrelevant. The fact that people can also be murdered with knives does not prove that a man standing over a dead body with a smoking revolver in his hand is not guilty of murder.

Others will say that one decision is no big deal; it’s the future path of policy that matters.  That’s also true, but decisions can tell us a lot about the Fed’s mindset, and hence the likely future path of policy.  As Tim Duy recently pointed out, the reason the markets care so much about the measly quarter point increase is not the direct effects on the economy, but rather what it tells us about the Fed’s reaction function.

The October 8, 2008 rise in IOR was neither a necessary nor sufficient condition to produce the Great Recession.  But it was one important part of the story, which began in 2008 and still has not ended.  Believe it or not a rate rise in September 2015 would help cause the recession of 2008, as the severity of that recession was partly caused by the perception that the Fed would raise rates before we got back to the previous NGDP trend line.  (An idea Krugman developed back in 1998.) And now the Fed is about to confirm that perception.

PS.  Now reread the final sentence of the opening paragraph.

PPS.  I have a new post at Econlog on a related issue.