Washington has produced lots of policy in response to the Great Recession. TARP, the $800 billion stimulus, Dodd Frank, HAMP and HARP, the QEs.But would policymakers have acted differently if they had thought differently about what caused the Great Recession? The common explanation for the downturn places the housing bust and the resulting financial crisis at the epicentre.
But Robert Hetzel, a senior economist at Federal Reserve Bank of Richmond, offers an alternative explanation in The Great Recession: Market Failure or Policy Failure, Hetzel pins the blame squarely on the Federal Reserve and Team Bernanke.
A moderate recession became a major recession in summer 2008 when the [Federal Open Market Committee] ceased lowering the federal funds rate while the economy deteriorated. The central empirical fact of the 2008-2009 recession is that the severe declines in output that in appeared in the [second quarter of 2008 and the first quarter of 2009] … had already been locked in by summer 2008.
Not only did the Fed leave rates alone between April 2008 and October 2008 as the economy deteriorated, but the FOMC “effectively tightened monetary policy in June by pushing up the expected path of the federal funds rate through the hawkish statements of its members. In May 2008, federal funds futures had been predicting the rate to remain at 2% through November. By mid-June, that forecast had risen to 2.5%.
As Hetzel writes in a Fed paper that inspired the book. “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”
In a new blog post, economist David Beckworth offers two charts in support of Hetzel. The first shows the passive tightening referred to earlier:
Photo: AEI, FRED
This second chart shows that the economy whether the housing collapse until this passive tightening created expectations of a sharp downturn and long-term drop in wealth. Then it tanked. Hetzel:
In early fall 2008, the realisation emerged that recession would not be confined to the United States but would be worldwide. That realisation, as much as the difficulties caused by the Lehman bankruptcy, produced the decrease in equity wealth in the fall of 2008 as evidenced by the fact that broad measures of equity markets fell by the same amount as the value of bank stocks … Significant declines in household wealth have occurred at other times, for example, in 1969–1970, 1974–1975, and 2000–2003. However, during those declines in wealth, consumption has always been considerably more stable, at least since 1955 when the wealth series became available. This decline in consumption suggests that the public expected the fall in wealth to be permanent.
Photo: AEI, FRED
Politicians can continue blame to Bush and the banks and free-market capitalism for the Great Recession, just as some folks still blame Hoover and Wall Street for the Great Depression. But in both cases, it was the Fed.