According to Geithner, the Fed was the “hero”

Robert Samuelson comments on Geithner´s book:

To critics left and right, Geithner is a reviled figure for his part in propping up Wall Street and rescuing many overextended firms. Geithner headed the New York Federal Reserve Bank (2003-09) and was President Obama’s first Treasury secretary (2009-13). His rebuttal is what he calls the “paradox of financial crises.” You have to save the financial system, even if the financial system — through poor lending and reckless speculation — got you in trouble.

He writes:

“When the financial system stops working, credit freezes, savings evaporate, and demand for goods and services disappears, which leads to layoffs and poverty and pain. When investors and creditors start to panic, consumers and businesses follow suit.”

The argument- that banks (the financial system) were the culprits – and variants thereof, have become the conventional wisdom relating to the causes of the crisis. As Tim Congdon puts in “What were the causes of the Great Recession  – The mainstream approach vs the monetary interpretation” – (World Economics, April-June 2014 forthcoming):

Mainstream thinking has appeared in many places, if with a variety of emphases. A salient strand has been that financial market practitioners took excessive risk relative to capital, with their actions motivated by inordinate ‘animal spirits’.

The “Fed as hero” is not an exaggeration. Two years ago this was the cover of The Atlantic:


Here I´ll try to highlight the monetary nature (causes) of the economic downfall.

The charts contrast the 2001 cycle with the 2007 cycle. The variables highlighted are nominal spending growth (NGDP growth), real output growth (RGDP growth), employment, unemployment and inflation (PCE-Core). All growth rates are percent year on year. For each pair of variables, the chart scale is the same to make comparisons easier.



Take away: Nominal spending growth, something over which the Fed has inordinate influence, sets the tune for real growth, employment, unemployment and inflation. In 2003, with the economy facing low real growth, falling employment, stubbornly high unemployment and inflation deemed too low, the Fed introduced “forward guidance” (FG) on interest rates. The economy´s reaction was immediate.

In contrast, the QEs of the 2007 cycle, first introduced in March 2009 after nominal spending growth had tanked, were a far cry from the effectiveness of the FG strategy of 2003.

Why the very different outcomes?  Why did nominal spending fall so much more in the 2007 cycle? Why was the FG strategy effective while the QE strategy much less so?

It all comes down to monetary policy. Unfortunately the popular interest rate (Fed Funds) measure is a very misleading gauge of monetary policy. As Friedman said more than 40 years ago in a Monetary Theory of Nominal Income:

[T]he present addendum to my earlier paper [A Framework for Monetary Analysis] suggests a third way to supply the missing equation.

This third way involves bypassing the breakdown of nominal income between real income and prices and using the QT to derive a theory of nominal income rather than a theory of either prices or real income.

[T]his simple model for analyzing short term economic fluctuations seems to me more satisfactory than either the simple QT, which takes real output as determined outside the model and regards economic fluctuations as a mirror image of changes in the quantity of money, or the simple Keynesian income-expenditure theory which takes prices as given and regards economic fluctuations as a mirror image of changes in autonomous expenditure.

[I]n particular, the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly, and low rates, that money has been tight, in the sense of increasing slowly, rather than the reverse.

[F]or monetary theory, the key question is the process of adjustment to a discrepancy between the nominal quantity of money demanded and the nominal quantity of money supplied…[T]he key insight of the QT approach is that such a discrepancy will be manifested primarily in attempted spending, hence in the rate of change in nominal income. Put differently, money holders cannot determine the nominal quantity of money, but they can make velocity anything they wish.

The charts below illustrate the stance of monetary policy, independently of the level of interest rates. If nominal spending (NGDP) falls below its trend level, this is indicative that monetary policy is “tight”. If it goes above, monetary policy is deemed loose.


Takeaway: In the 2001 cycle, monetary policy was initially too “tight”, but forward guidance succeeded in “loosening it up”, so that nominal spending ‘travelled’ back to trend.

For the most recent cycle we notice that monetary policy began to ‘tighten up’ as soon as Bernanke took over at the Fed. The ‘monetary screws’ were slowly tightened with spending increasingly falling below trend until it collapsed after mid-2008.

The next charts show why things worked out the way they did.


Takeaway: Between 2000 and mid-2003, while velocity growth was still negative (money demand increasing) broad money supply growth was significantly reduced. When forward guidance was implemented velocity growth becomes positive (money demand is reduced) while money supply growth remains stable. This combination, according to Friedman´s thermostat [see note below], guarantees that spending will rise.

In 2006, on the contrary, velocity growth turns negative (money demand begins to rise) while money supply growth remains ‘constant’. We see why nominal spending collapsed after mid-2008. With money demand still rising (velocity growth negative) money supply growth turned down strongly.

And the recovery which began in mid-2009 remains sluggish because money supply growth has not been strong enough to more than offset the increase in money demand and allow spending growth to ‘travel back’ towards somewhere close to the original trend level. By keeping spending growth at around 4% may be enough for a ‘sluggish recovery’ but quite insufficiet for a ‘full-blown’ one.

The monetary interpretation of the Great Recession explains both the deep fall and the sluggish recovery. In this case, the magnitude of the financial crisis is a consequence of the Fed mishandling monetary policy.

An alternative explanation that has gained traction with the publication of their book is discussed by Binyamin Appelbaum in “The Case Against the Bernanke-Obama Financial Rescue”:

 Atif Mian and Amir Sufi are convinced that the Great Recession could have been just another ordinary, lowercase recession if the federal government had acted more aggressively to help homeowners by reducing mortgage debts.

The two men — economics professors who are part of a new generation of scholars whose work relies on enormous data sets — argue in a new book, “House of Debt,” out this month, that the government misunderstood the deepest recession since the 1930s. They are particularly critical of Timothy  Geithner, the former Treasury secretary, and Ben Bernanke, the former Federal Reserve chairman, for focusing on preserving the financial system without addressing what the authors regard as the underlying and more important problem of excessive household debt. They say the recovery remains painfully sluggish as a result.


Americans lost a similar amount of wealth during the housing crash as during the collapse of Internet-related stocks in 2000, but the economic consequences of the housing crash were much larger. The difference, in the view of Mr. Bernanke, the former Fed chairman, and other economists, is that the housing crash precipitated a financial crisis. Mr. Bernanke has noted that the worst of the economic downturn did not begin until the markets crashed in the fall of 2008, and that it ended once the financial crisis was arrested. The recovery has been slow, he has said, because of factors including cuts in government spending and Europe’s malaise.

“There were weaknesses in the financial system that transformed what might otherwise have been a modest recession into a much more severe crisis,” Mr. Bernanke said in a 2012 lecture at George Washington University. “It was not just the decline in house prices,” he added. “It was the whole chain.”

As I argued, what “fired the chain” was the Fed´s own bungling!

Update: Related but goes in a ‘fiscalt direction’.

[Note] In 2003, Friedman gave the simplest explanation for the “Great Moderation” with his “thermostat analogy”. In essence, the new found stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable. Note that PY or its growth rate (p+y), contemplates both inflation and real output growth, so that stabilizing nominal expenditures along a level growth path means stabilizing both inflation and output.


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