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Misdiagnosing the crisis: The real problem was not

real, it was nominal

10 September 2009

Do most macroeconomists hold views of this crisis that are entirely at variance with modern monetary
economics? This column says that tight monetary policy caused the crisis. Economists seem not to
believe what they teach about the fallacy of identifying tight money with high interest rates and easy
money with low interest rates.

Here is a puzzle. Almost everything we have learned from recent research in monetary history,
theory, and policy points to the Federal Reserve as the cause of the crash of late 2008. More
specifically, an extremely tight monetary policy in the US (and perhaps Europe and Japan) seems to
have sharply depressed nominal spending after July 2008. And yet it is difficult to find economists
who believe this. More surprisingly, few economists are even aware that their views conflict with the
standard model, circa 2009.

In this column, I will not try to describe my view of the crisis but rather argue that there is a puzzle
that needs to be addressed – why do most macroeconomists hold views of this crisis that are entirely
at variance with modern monetary economics?

Was monetary policy tight in late 2008?

Let’s start with my argument that money was very tight in late 2008. Most economists have assumed
that the Fed adopted a policy of extreme ease in late 2008. Perhaps so, but I have yet to see a
persuasive argument for this assumption. Some would point to the fact that the Fed cut its target
rate to very low levels in 2008. Is that reasoning any different from when (in 1938) Joan Robinson
argued that easy money couldn’t have caused the German hyperinflation, as interest rates in
Germany were not low?

Surely in the 21st century we aren’t still using nominal interest rates as an indicator of the stance of
monetary policy? Friedman and Schwartz (1963) demonstrated that interest rates are a very poor
indicator on monetary policy. In the early 1930s, the Fed cut its discount rate just as sharply as in
2007-08, and yet today almost no one believes money was easy during the Great Contraction.

Mishkin’s best-selling monetary economics textbook teaches our students that:

“It is dangerous always to associate the easing or the tightening of monetary policy with a fall or
a rise in short-term nominal interest rates.”

Do we actually believe what we teach our students? When Japan hit the zero rate bound in the late
1990s, there was a similar perception that “easy money” had failed to boost aggregate demand.
Friedman’s reaction suggests that the profession was still as confused as Joan Robinson:

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest
rates, that money has been easy. . . . After the US experience during the Great Depression, and
after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in

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the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy
money with low interest rates was dead. Apparently, old fallacies never die.” (Friedman 1997)

Real versus nominal interest rates

At this point some economists will say, “Yes, nominal rates can be misleading, but real rates are a
pretty good indicator of monetary problems.” There are problems with this view.

First, it is not necessarily true in theory. Robert King (1993) showed that, in a forward-looking
rational expectations model, easy money can raise both nominal and real interest rates.
Second, if real rates are the “right” monetary policy indicator, then monetary policy became
extraordinary tight in late 2008. The only objective estimate of ex ante real interest rates that
we have – the spread between the yields on conventional and indexed bonds – soared
dramatically between August and November 2008.

Quantity measures of monetary policy

The next line of the monetary-policy-was-loose argument points to the monetary base, which doubled
in late 2008. But monetary history teaches us that the base is also an unreliable indicator of policy.
The base rose sharply between 1930 and 1933, and yet nominal GDP fell roughly in half.

Even worse, most economists ignored the Fed’s 6 October 2008 decision to start paying interest on
reserves – which meant the Fed bribed banks to hoard all the extra liquidity they were injecting into
the system. If this sounds unfair, consider that the Fed itself indicated that these payments were
necessary to prevent market interest rates from falling; an explanation that Woodward and Hall
(2008) correctly described as “a confession of the contractionary effect.”

The Fed’s decision to double reserve requirements in 1936-37 is often cited as a contractionary
mistake that prolonged the Depression. The 2008 decision to pay interest on reserves had the same
effect, increasing the demand for reserves. Surprisingly, few economists seemed to notice the
parallels with 1937, despite the fact that in 2009 nominal GDP is expected to fall at the fastest rate
since 1938. I have argued that the Fed should instead charge a penalty rate on excess reserves, and
the Swedish Riksbank recently adopted this strategy.

But what about the broader monetary aggregates that increased in 2008? If we learned anything
from the 1980s, it is that the broader aggregates are no more reliable than the base. During financial
turmoil, it is not surprising that there is an increased demand for safe, FDIC-insured bank deposits.

What are reliable indicators of monetary policy?

Mishkin’s text suggests one indicator: “Other asset prices besides those on short-term debt
instruments contain important information about the stance of monetary policy.” How did those other
asset prices perform during the crucial period from July to November 2008?

The stock market crashed.

Commodity prices crashed.
Yields on indexed bonds soared.
The conventional/indexed bond yield spread went negative.
The dollar soared against the euro.
The housing crash spread from the sub-prime markets to heartland cities where prices had held
up relatively well in late 2007 and early 2008.

This last point deserves emphasis. There were actually two housing crashes. The first (in 2007 and
early 2008) was concentrated in markets heavily affected by speculation. The second was nationwide,
exactly what one would expect from a monetary policy tight enough to sharply reduce nominal GDP.

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To summarise – six asset markets provide six indicators of monetary policy being far too
contractionary for the needs of the economy. So if we are going to take seriously what we teach our
students in monetary economics classes, then money was exceedingly tight in late 2008.

When did the Fed lose credibility?

Recent research by Svensson (2003) and others has emphasised the importance of “targeting the
forecast.” Thus the Fed should adopt a policy stance expected to produce on target growth in their
preferred indicator of demand. This might be 2% inflation, or 5% nominal GDP growth. Policy is
credible when markets expect the Fed to hit its target. Policy would be too contractionary if the Fed
set an explicit 2% inflation target, but markets expected 1% deflation. Svensson argues that central
banks should ease or tighten policy as much as necessary for their own internal forecast of inflation to
equal the inflation target.

When did the Fed lose credibility? It depends on which forecast you think they should target. I have
argued that the Fed should target market forecasts, in which case policy was too contractionary by
mid-September 2008, when market forecasts for inflation and real growth were both very low. Indeed
Hetzel (2009) argued policy was already too tight in August 2008. If we use the Fed’s internal
forecast, policy lost credibility in October 2008. By then, even the Fed acknowledged that
medium-term inflation and real growth would be much lower than any plausible estimate of the Fed’s
implicit target.

But isn’t monetary policy irrelevant with zero nominal interest rates?
Another point to address is the belief that monetary policy cannot be a cause of the crisis since
monetary policy is ineffective when nominal rates are (near) zero bound. This is simply a
misunderstanding of modern macro. To quote Mishkin’s textbook:

“Monetary policy can be highly effective in reviving a weak economy even if short-term interest
rates are already near zero.”

And once again monetary history provides important lessons. Conventional open market purchases
failed to significantly boost nominal spending in 1932, but in the first four months after FDR set an
explicit price level target in 1933, nominal spending soared at the fastest rate in US history. And this
occurred despite the fact that much of the US banking system was shut down for months. There is no
evidence that a financial crisis prevents monetary stimulus from boosting nominal GDP. Ironically, an
important paper documenting the success of FDR’s policy – Eggertsson (2008) – was published in
September 2008, the very month that monetary policy errors led to the crash of 2008.

The Fed’s failure

Woodford (2003) emphasised how expectations of future monetary policy and aggregate demand
impact current demand. An explicit price level or nominal GDP trajectory going several years forward
would have helped stabilise expectations in late 2008. Because the Fed failed to set an explicit target
path (level targeting), expectations became very bearish in late 2008. Contrary to what many
economists assumed, tight money was already sharply depressing the economy by August 2008. After
the failure of Lehman most economists simply assumed that causation ran from financial crisis to
falling demand. This reversed the primary direction of causation – as in the Great Depression,
economic weakness worsened bank balance sheets and intensified the financial crisis in late 2008.

We need to pay attention to what the markets are telling us

A recent Vox column by Carmassi, Gros, and Micossi expressed the widely held view that the roots of
this crisis lay in overly accommodative Fed policy during the housing bubble. Policy was a bit too easy

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during that period, as nominal GDP growth was slightly excessive, but if we are going to take market
efficiency seriously then the primary cause of the severe worldwide recession should have occurred
when the markets actually crashed. Yes, the tech and housing bubbles showed that markets are not
always efficient. But that is no reason to ignore market signals.

On my blog, I have argued that the simultaneous declines in stocks, commodities, and industrial
production during late 2008 were eerily similar to late 1929 and 1937. All three crashes occurred as
monetary policy errors led investors to dramatically scale back their forecasts for nominal growth
going several years forward. Each market crash was followed by one of the most severe contractions
of the past 100 years. It is difficult to overstate the importance of maintaining policy credibility with
explicit target trajectories for prices or nominal GDP.

The challenge to the profession

Economists need not agree with my view that tight money caused the current recession. But they do
need to find counterarguments that do not rely of assumptions that have been thoroughly discredited
by recent developments in monetary economics. Fed policy generally reflects the consensus view of
elite macroeconomists. If I am right, it was a massive intellectual failure within the economics
profession, not reckless bankers, that caused the crash of 2008. This was a failure to trust our own
models.

Author’s note: I have benefited from discussions with William Woolsey, David Glasner, and Earl
Thompson, who each independently reached many of the views discussed here.

References
Carmassi, Jacopo; Gros, Daniel; and Stephano Micossi (2009). “Simple explanations for global
financial instability and the cure: Keep it simple.” VoxEU.org, 13 August, 2009.
Eggertsson, Gauti, B. 2008. “Great Expectations and the End of the Depression.” American Economic
Review. 98, 4, 1476-1516.
Friedman, M. and Schwartz, A. A Monetary History of the United States, 1867-1960, Princeton,
Princeton University Press, 1963.
Friedman, Milton. “Rx for Japan: Back to the Future.” Wall Street Journal. December 17, 1997.
Hetzel, Robert. “Monetary Policy in the 2008-2009 Recession.” Federal Reserve Bank of Richmond,
Economic Quarterly. Spring, 2009.
King, Robert G. 1993. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal
of Economic Perspectives. 7, 1, pp. 67-82.
Mishkin, Frederic. 2007. The Economics of Money, Banking, and Financial Markets. Eighth edition.
Boston: Pearson Education.
Sumner, Scott. 2006. “Let a Thousand Models Bloom: The Advantages of Making the FOMC a Truly
‘Open Market’.” Berkeley Electronic Journals, Contributions to Macroeconomics. 6, 1, Article 8.
Sumner, Scott. 2009. “Comment on Brad Delong: Can We Generate Controlled Reflation in a Liquidity
Trap?” Berkeley Electronic Journals, The Economists’ Voice, Volume 6, Issue 4, Letters.
Svensson, Lars E.O. 2003. “What is Wrong with Taylor Rules? Using Judgment in Monetary Policy
Through Targeting Rules.” Journal of Economic Literature, 41, pp. 426-77.
Woodford, Michael. 2003. Interest and Prices, Princeton: University of Princeton Press.
Woodward, Susan, and Robert Hall. 2008. “Options for Stimulating the Economy”, December 8, 2008.

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Topics: Macroeconomic policy

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