Weaving a narrative through the facts

Four recent posts: Matt Yglesias, Noah Millman and Scott Sumner, present a discussion of the “foundations” of the crisis. Scott Sumner also takes on “allegations” by Keynesians on fiscal stimulus.

Yglesias started it off with the pointed question: “When did the Fed screw up?”

And all that time from the latter part of 2005 through all of 2006 and 2007 and through the beginning part of 2008, the Federal Reserve is basically doing its job correctly. Inflation expectations are remaining stable. Construction workers are losing their jobs, but there’s no broader economic collapse.

It’s only in the second half of 2008 that the monetary situation goes haywire, inflation expectations plunge, and the whole economy goes to crap.

Here I´ll “beef-up” his arguments by way of a series of illustrations, with bars marking the moment “events” took place. The first chart shows house prices (the “trigger”).

The next charts indicate 1: the drop in residential investment was “offset” by a rising nonresidential investment, both relative to GDP and, 2: the fall in residential construction employment was at least partially offset by the employment increase in non residential construction.

The next chart shows both the level and change in total non farm employment (NFP). Things only really “go bad” after mid 2008.

That´s when nominal spending (NGDP) “tanks”.

Why did that happen? House prices had already dropped quite a bit. Financial problems begin to show up in early 2007 (the “official start date” of the financial crisis is early August 2007 when 3 Funds in Bank Paribas closed for redemptions). The NGDP & Trend chart above indicates that after the start of the recession (December 2007) nominal spending was “making its way” back to trend. But then, the “floor” opened and spending took a “dive”.

Market Monetarists would say that money demand increased (velocity fell) and money supply did not offset it. The charts below indicate that´s exactly what happened. Up to early 2008, falling velocity was offset by rising money supply, not so afterwards. That monetary policy error proved very costly. Moreover, all the “debate” about fiscal stimulus, which has brought so much chagrin wouldn´t have happened if the Fed had not “botched” it!

But what could have induced the Fed into error? The chart below shows the behavior of different measures of inflation. Oil and commodity prices rose significantly, impacting headline PCE inflation, while core inflation remained tamed. All through the first half of 2008 the FOMC meetings were “nervous” and were mostly focused on the inflation risk (as late as August there was a dissenting vote and the statement clearly indicated that inflation posed the higher risk). Unfortunately after many years of “tracking” the behavior of core inflation, the Fed decided to elevate the status of headline inflation. If an inflation target is bad (especially after inflation has been “conquered”), a “headline target” is much worse!

So I come to the end of the “narrative”. Yes, house prices fell. Yes, financial sector problems followed. Yes, the economy went into recession. But monetary policy errors are, alone, responsible for the “depression” that ensued. And a “side-effect” of that error was to awaken those who believe government is “all powerful” and those who want to “End  the Fed”!

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