Versions of this story have been told several times by market monetarists (MM). Given that “the other side” insists in pushing the “conventional wisdom”, I feel free to concoct yet another version of the MM story.
The New York Fed just came out with a study titled: “The Failure to Forecast the Great Recession”. The story told follows the “conventional script”:
The economics profession has been appropriately criticized for its failure to forecast the large fall in U.S. house prices and the subsequent propagation first into an unprecedented financial crisis and then into the Great Recession.
Note that there is no role for monetary policy in this “transmission process”. Actually, it´s worse because “excessively expansionary” monetary policy during 2002-05 is usually alleged to be a root cause of the house “bubble”.
The St Louis Fed has a convenient “Crisis Time-Line” in its site. The start date is February 2007. The events in first few months of the crisis are detailed below:
February 27, 2007 | Freddie Mac Press Release
The Federal Home Loan Mortgage Corporation (Freddie Mac) announces that it will no longer buy the most risky subprime mortgages and mortgage-related securities.
April 2, 2007 | SEC Filing
New Century Financial Corporation, a leading subprime mortgage lender, files for Chapter 11bankruptcy protection.
June 1, 2007 | Congressional Testimony
Standard and Poor’s and Moody’s Investor Services downgrade over 100 bonds backed by second-lien subprime mortgages.
June 7, 2007
Bear Stearns informs investors that it is suspending redemptions from its High-Grade Structured Credit Strategies Enhanced Leverage Fund.
June 28, 2007 | Federal Reserve Press Release
The Federal Open Market Committee (FOMC) votes to maintain its target for the federal funds rate at 5.25 percent.
July 11, 2007 | Standard and Poor’s Ratings Direct
Standard and Poor’s places 612 securities backed by subprime residential mortgages on a credit watch.
July 24, 2007 | SEC Filing
Countrywide Financial Corporation warns of “difficult conditions.”
July 31, 2007 | U.S. Bankruptcy Filing
Bear Stearns liquidates two hedge funds that invested in various types of mortgage-backed securities.
August 6, 2007 | SEC Filing
American Home Mortgage Investment Corporation files for Chapter 11 bankruptcy protection.
August 7, 2007 | Federal Reserve Press Release
Fomc votes to maintain its target rate for the federal funds rate at 2.5%
August 9, 2007/BNP Paribas Press Release
BNP Paribas, France´s largest bank, halts redemption on three investment funds
That seems right because it´s exactly after February 2007 that the Case-Shiller HPI begins its downslide. Apparently Freddie Mac´s decision to no longer buy risky subprime mortgages was instrumental in “popping the bubble”.
Despite that fact, the next picture indicates that unemployment remained low.
At least until nominal spending began to fall in mid 2008.
And why does nominal spending drop? Here´s where the MM viewpoint comes into play. The next picture shows that when the crisis began, velocity started to fall (money demand to rise). This was offset by an increase in the growth of money supply. As a result, nominal spending (NGDP) continued to rise and unemployment remained contained. When, despite the continued fall in velocity, money supply growth reversed, nominal spending growth turned negative and the recession became “Great”, worsening the ongoing financial crisis (Lehman) from the fall in house prices.
In this sense, the “Great Recession” is a monetary phenomenon. And we shouldn´t forget that the “depressive state” in which the economy remains more than two years after the official end of the recession is also due to the failure of monetary policy to give the needed boost to aggregate demand.
At the end of the note the author writes:
However, the biggest failure was the complacency resulting from the apparent ease of maintaining financial and economic stability during the Great Moderation. Perhaps most important, as noted by some analysts as early as the 1990s, these adverse consequences of the Great Moderation were most likely to arise from the actions, judgments, and decisions of financial market participants.
I gather from that that every once in a while policymakers have to “surprise the markets” lest it becomes “complacent”!