I was bugged by an argument put forth by Neil Fligstein, Jonah Brundage and Michael Schultz, from the Department of Sociology at UC-Berkley in their recent paper “Why the Federal Reserve Failed to See the Financial Crisis of 2008: The Role of “Macroeconomics” as a Sensemaking and Cultural Frame”.
According to them:
The Fed´s main analytic framework for making sense of the economy, macroeconomic theory, made it difficult for them to connect disparate events that comprised the financial crisis into a coherent whole.
I don´t think so. I prefer to cast the role of the FOMC, in particular its chairman, as one of ‘scriptwriting’. By that I mean having the capacity, through macroeconomic analyses, to have a feel for the environment (including the shocks) and based on that to write the best ‘script’ possible to guide the economy across the “twists and turns” that comprise ‘reality’.
Obviously, some ‘scriptwriters and scripts’ are better than others. I´ll examine the nature of ‘scripts’ written over the years since 1997. I like 1997 because I think there were several ‘defining events’ that taxed the ‘scriptwriting’ capacity of the Fed.
The ‘defining events’ of 1997:
- After spending the prior years flat/falling, real labor compensation (and labor share) began to increase strongly
- Productivity continued to rise strongly
- Corporate profits peaked and then fell
- The dollar began to rise (appreciate) in real terms relative to a broad basket of currencies
- The US current account took a dive
- House prices began their accent
- Unemployment and inflation dropped significantly
- The ‘Asia crisis’ happened
How are these ‘events’ (or facts) connected? Can macroeconomic theory help?
Before 1997, the positive supply shock from the increase in productivity growth was driving unemployment and inflation down. In 1996 and 1997 some FOMC members were worried about the possible inflation consequences of too low unemployment. When the FOMC raised rates by 25 basis points in March 1997, outside pundits were sure that would be the first of a long series of rate increases!
They were wrong. Greenspan the ‘head scriptwriter’ thought that productivity gains and worker ‘insecurity’ were holding down both compensation and inflation. The worker ‘insecurity’ argument was just ‘story telling’ because right at that point worker ‘insecurity’ went ‘out the window’ and compensation took off.
What about the other ‘events’ and how can the rise in compensation be explained? In other words, can the ‘dots be connected?’
The Asia crisis was an Asian balance of payments crisis. Thailand, Malasia, Indonesia, Korea, and others were generating high current account deficits and there was a “sudden stop” in the financing of those deficits, with those countries having to do an immediate reversal.
To make such a reversal possible, there must be another country to do the opposite move. That country was the US, whose current account deficit begins to increase very fast.
But how does this adjustment take place. ‘Asia’ has to divert resources from the non-tradable to the tradable sector. The US has to do the opposite. In ‘Asia’ resources move out of housing and in the US they move towards housing (imagining ‘housing’ as the representative non tradable).
To promote the adjustment relative prices must change. The dollar appreciates, and real labor compensation rises in the US and falls in ‘Asia’.
House prices in the US rise and fall in ‘Asia’.
The rise in real compensation at a higher rate than productivity growth increases labor´s share and reduces profits (capital´s share). [Fast forward: In 2001 the SEC identified ‘rogue’ corporations (Enron et al) that had been “cooking the books” since 1997. Those corporations with bad governance decided, given the executive pay scheme in place, that that would be the way to compensate for the fall in profits (which followed from the rise in labor share, which was a consequence of the balance of payments adjustment imposed by the ‘Asia’ crisis)]!
Update (Marc 15) Josh Barro writes: “People-think-were-in-a-recession-don´t-blame-them”
The one period of really robust wage growth in the last 40 years was the late 1990s, when the labor market was tight and workers could effectively demand higher wages in exchange for their labor. Fiscal and monetary policies that aim to recreate that situation might finally get Americans to stop saying we’re in a recession. Yet that’s not the focus of the conversation in Washington.
At the time, public sector deficit was turning into surplus and monetary policy strived for nominal stability. A productivity shock was underway and there was the requisite economic adjustment to the Asia crisis. This last was, as I showed, the linchpin for the steep rise in labor compensation. Even if “Asia crisis conditions” cannot be replicated, striving for nominal stability (and fiscal consolidation) will do wonders for the labor market.
In this environment what ‘script’ did the Fed ‘write’? As observed above, there was a lot of pressure for the Fed to tighten (i.e. increase the Fed funds rate). Although Greenspan strongly resisted, even reducing rates following the Russian crisis in August 1998, in mid-1999 he began increasing the FF rate, which went from 4.75% to 6.5% by mid-2000.
But the interest rate ‘script’ is just for “general consumption”. Between 1992 and 1997 the implicit ‘script’ was targeting NGDP. I´m not making this up. During the December 1992 FOMC meeting there was a detailed discussion of NGDP Targeting. Concluding the discussion SF Fed President Parry says (transcripts pp 24-27)
I’m afraid a lot of the academic literature would suggest that we probably would reduce the chance of making the kinds of mistakes that we make with interest rate targeting if we followed a nominal income target.
Pity that Parry´s very perceptive closing was forgotten during the heat of the 1997 ‘events’. What happened in fact, as the figure illustrates, is that the stance of monetary policy (measured not by the level of the FF rate, but by NGDP differing from the target level) became quite expansionary.
Towards the end of 2000, the Fed began reigning-in monetary policy, but as we move towards the next frame in the ‘movie’, the Fed ‘over tightened’ (despite the steep fall in the FF rate!). This is evidenced by the deep drop in NGDP below the target level.
Inflation remained low, even falling somewhat and unemployment shot up.
House prices remained on their previous up trend and so did productivity. Labor compensation increased by less than productivity, so profits picked up again.
By mid-2003 the FOMC came to the realization that interest rate policy, even if rates were at an extremely low level by historical standards, was not ‘doing the job’. The ‘script’ had to be adapted. That was when “forward guidance” (FG) was introduced. The effects were quick to show up.
NGDP began climbing towards trend, unemployment travelled south and inflation increased towards the “target level”.
By the end of his tenure, ‘scriptwriter’ Greenspan had brought the ‘story’ back to its ‘trend level’. At that point, another ‘scriptwriter’ took over.
While Greenspan´s ‘scripts’ were vaguely defined – one of Greenspan´s favorites was “appropriate monetary policy” – Bernanke´s ‘script’ was much more ‘precise’. Long before imagining he would be Fed Governor, let alone Chairman, Bernanke had ‘specified’ his ‘favored ‘script’, and that was “inflation targeting”. This is what he wrote in January 2000:
U .S. monetary policy has been remarkably successful during Alan Greenspan’s 121/2 years as Federal Reserve chairman. But although President Clinton yesterday reappointed the 73-year-old Mr. Greenspan to a new term ending in 2004, the chairman will not be around forever. To ensure that monetary policy stays on track after Mr. Greenspan, the Fed should be thinking through its approach to monetary policy now. The Fed needs an approach that consolidates the gains of the Greenspan years and ensures that those successful policies will continue; even if future Fed chairmen are less skillful or less committed to price stability than Mr. Greenspan has been.
We think the best bet lies in a framework known as inflation targeting, which has been employed with great success in recent years by most of the world’s biggest economies, except for Japan. Inflation targeting is a monetary-policy framework that commits the central bank to a forward-looking pursuit of low inflation; the source of the Fed’s current great performance; but also promotes a more open and accountable policy-making process. More transparency and accountability would help keep the Fed on track, and a more open Fed would be good for financial markets and more consistent with our democratic political system.
In fact “Inflation Targeting” was a bad choice of ‘script’ at the wrong time. In short, successful inflation targeting central banks had opted for the choice when inflation was high and central banks were short on credibility. This was not the case of the US in 2007. By pushing his ‘script’ Bernanke made inflation THE variable to watch.
So everyone was watching when the oil shock hit and headline inflation jumped (even though core inflation remained quite tame). It´s quite possible that the “appropriate monetary policy” spiel favored by Greenspan would have had a less damaging effect.
House prices had peaked in early 2006 but remained close to that level for the next year. Only when expectations of future nominal growth were reduced, quickly followed by the decline of actual nominal spending, did house prices begin to drop and the financial crisis to take it´s final shape.
And the ‘inflation script’ remained intact all the way to the fall of 2008. At that point the outlook became so negative that ‘scriptwriting’ became a feverish activity. The FOMC could certainly have rescued the NGDP targeting idea of 1992, but to everyone´s loss it didn´t!