A decade has passed since the global financial crisis. Although the economy currently appears healthy, an increasing number of economists are predicting a recession by 2021.
Predicting recessions is a notoriously imprecise gambit, especially since bad monetary policy is so often the key factor in causing an unsustainable boom or unnecessarily deep recession. Still, the occasion of 10 years since the worst economic downturn since the Great Depression is as good a time as any to assess the current state of monetary policy.
Have monetary policy makers learned from their mistakes in combating the Great Recession? Are we in a better or worse position to respond to the next recession, whenever it may come?
Lawrence H. White and I consider these questions in the latest special edition of the Cato Journal, “Monetary Policy 10 Years After the Crisis.” In the paper, we make three major observations about monetary policy over the past decade.
1. The Fed’s actions exacerbated the housing bubble and resulting financial crisis.
At the outset, it’s worth noting that the Fed itself was largely responsible for the credit crunch that sparked the financial crisis. Easy money might have helped fuel the housing bubble in the early- to mid-2000s, but excessively tight money in the early stages of the crisis almost certainly turned what should’ve been a garden-variety recession into the Great Recession.
Rather than providing sufficient liquidity in a timely manner to prevent the bursting of the housing bubble from spiraling into an economy-wide credit contraction, the Fed chose to siphon liquidity toward specific firms and sectors at the expense of the general economy. Two of the main beneficiaries of this “preferential credit allocation” were the Fed’s primary dealers (two dozen or so of the largest, “too big to fail” banks that serve as the Fed’s counterparties when it conducts open market operations) and firms heavily invested in the housing sector. To quote from our article: "In all of its mid-crisis and post-crisis improvisation, the Fed departed from a focus on overall market liquidity and stability of aggregate demand. It allocated credit to specific firms and sectors at the expense of the general market." (p. 370)
Even when the Fed belatedly realized that it needed to inject more reserves in late 2008, it did so in a clumsy and ineffective manner through quantitative easing. The Fed doubled the monetary base in late 2008. However, it counteracted this stimulus by simultaneously paying banks above-market interest on reserves to incentivize them not to make loans for fear that this unprecedented monetary expansion might stoke inflation.
The Fed was, in effect, driving the economy’s escape car with one foot slammed on the gas pedal and one foot slammed on the brakes. It’s no wonder this hamfisted policy framework resulted in the slowest recovery since the Great Depression. Thomas Hogan has estimated that this policy alone accounted for more than half the post-crisis decline in bank lending.
2. The Fed violated long-standing norms about the proper role of monetary policy to allocate credit to preferred interest groups.
Ben Bernanke has argued the Fed’s bailouts and emergency lending programs were consistent with the classical “lender of last resort” doctrine outlined in Walter Bagehot’s heralded treatise Lombard Street (1873), which maintains that central banks should provide liquidity only to solvent but illiquid banks on good collateral at a penalty rate.
Bernanke’s claims are false, to put it bluntly. Throughout the crisis, the Fed consistently charged below-market rates on loans on questionable collateral to financial institutions (both banks and non-banks) that were, at best, teetering on the brink of insolvency. As noted earlier, it also channeled liquidity toward primary dealers and the housing sector at the expense of other banks and sectors. The dramatic expansion of its powers under Article 13 (3) of the Federal Reserve Act has opened the door to politicization of monetary policy by politicians and special interest groups. It has also set the stage for future crises by legitimizing “too big to fail” and creating more moral hazard in the financial system.
In short, the Fed failed in its mission to extinguish the financial wildfire that broke out in 2007-8. Many of its delayed and poorly designed actions exacerbated the crisis and set the stage for further politicization of monetary policy in the future.
3. The case for monetary rules is greater now than ever.
Given how drastically the Fed strayed from the proper (and limited) role of monetary policy, the case for adopting a strict monetary rule is stronger now than ever.
Some economists have argued for removing the second leg of the Fed’s dual mandate (full employment) so that it can instead focus on price stability (i.e., inflation targeting). In the same issue of the Cato Journal, David Beckworth and Scott Sumner make a strong case for a different (and, in my opinion, preferable) nominal target the Fed should focus on: NGDP targeting (for a contrasting viewpoint, read Jeffrey Frankel’s article objecting to strict rules).
Reasonable people can disagree as to what exact rule is best for monetary policy. But reining in Fed discretion should be a top priority for proponents of sound money. Congress has tossed around the idea of assessing the Fed based on monetary rules before. But the Fed has long been reluctant to confine itself to any one particular rule or standard for assessing its performance, for the same reason any bureaucracy would object to having to having its discretion curtailed.
If there’s a silver lining to the Fed’s erratic and unprecedented actions over the past decade, it’s that it has reinvigorated a debate over the political economy of monetary policy. This discussion was lively during the Great Stagnation of the 1970s, but unfortunately was largely dormant during the Great Moderation. Thankfully, sound-money scholars have already begun renewing the search for a monetary constitution, outlining what specific steps Congress and the Fed should take to bring us closer to a rules-based monetary system that is less vulnerable to political and special interests. But the debate is far from won, and time may well be running out to fix the Fed’s broken framework before the next crisis.