I like this quote from an old John Taylor post:
If the Fed had not kept interest rates so low when inflation was rising and the economy was growing in the 2002-2005 period, then we would have avoided much of the boom and the bust which eventually caused the devastating increase in unemployment.
He clearly identifies the “cause” of the crisis as being due to the Fed keeping “rates too low for too long”. Those low rates then fomented the house price bubble which, when the crash came along, gave rise to the “financial crisis”. And as is “well known”, a financial crisis requires a drawn out “healing” process.
Taylor is right in arguing that the crisis was due to monetary policy errors, only, as I´ll try to show, not the one he imagines.
The next picture shows that house prices (Case-Shiller) “took off” in 1997, long before the “too low for too long” period. Coincidently, 1997 was the year that Congress approved legislation exempting taxes on capital gains on the sale of primary residences every two years. Given the other conditioning factors encapsulated in the incentives to homeownership (that propelled subprime financing), this change in the tax rule is surely an important factor behind the observed house price rise. The process “snowballed” and, as usually happens with snow, it “melts”.
The year 1997 also witnessed a fact that defied the “conventional wisdom”: the simultaneous drop in inflation and unemployment. The next picture illustrates the “event” that left analysts “perplexed”.
The third piece of “evidence” is depicted in the next pictures, showing that productivity growth trended strongly up…and real growth surged to more than 4%!
The following picture shows that in the context of a Dynamic AS/AD model that outcome is to be expected.
The “productivity shock” shifts the AS curve down and to the right, with the economy moving from point a to point b. Real growth picks up (unemployment trends down) and inflation falls.
But as David Glasner just reminded us, inflation targeting can have perverse effects. With inflation dropping below target, the Fed put on its “inflation targeter hat” and “jacked up” spending growth, taking the economy to point c.
The next two pictures show that the Fed erred in reacting to a productivity shock and destabilized the economy which up to that point was evolving along a stable level growth path.
In the quarters that followed the “excessive growth of AD”, the Fed became queasy about the inflationary potential of a “too low” rate of unemployment and went on to “contract AD”. This “queasiness” was already being felt for some time by many analysts, among them Paul Krugman who wrote in 1997 that:
Most economists believe that the US economy is currently very close to, if not actually above, its maximum sustainable level of employment and capacity utilization. If they are right, from this point onwards growth will have to come from increases either in productivity (that is, in the volume of output per worker) or in the size of the potential work force; and official statistics show both productivity and the workforce growing sluggishly. So standard economic analysis suggests that we cannot look forward to growth at a rate of much more than 2 percent over the next few years. And if we – or more precisely the Federal Reserve – try to force faster growth by keeping interest rates low, the main result will merely be a return to the bad old days of serious inflation.
Other AD shocks – the internet crash, 9/11 and the accounting scandals (Eron et al., that affected “confidence”) also influenced and amplified the “contractionary” monetary policy. As the next figure shows, inflation remained below “target” throughout the period. So, in order to bring the economy back to its trend level, the Fed acted as it should (contrary to Taylor´s argument).
And note that throughout those years, be it with AD growing above trend or contracting, house prices “kept on rising” (figure 1 above), weakening the thesis that it was caused by a “too easy” monetary policy.
The pictures below show the “shape” of monetary policy. “Contractionary” in 1999 and during 2001-2003, with both velocity and money supply falling.
How has Bernanke fared? In 2006/07, despite the fall in house prices and in residential construction, monetary policy did a reasonable job in offseting changes in velocity and kept the economy chugging along close to its trend level.
But in 2008/09 he “lost his touch” and MP turned highly contractionary, certainly worsening the “financial crisis”.
According to Nick Rowe, “Recession/Depression is always a monetary phenomenon”. So no mystery that the “recession” ended in mid 2009. That was the time that monetary policy became “accommodative” (in the sense of offsetting movements in velocity (money demand)).
But the point is that that´s not enough to get the economy (spending) climb out of the “ravine” into which it fell. For that you would have to get the “shape” observed in 2005!
In his recent post, John Taylor is not sure about the meaning of the recent increase in money supply. Could it be indicating more inflation to come? Or is it telling us that things are getting “worse” because money demand is rising? Given the state of the economy he should have shown “no doubts”!
And tomorrow we have the much expected Bernanke speech at Jackson Hole. I´m pessimistic.