Tuesday Focus: Macroeconomics and the Crisis: March 4, 2014
I have already written about how the world looked as Paul Krugman saw it at the start of 2008:
Paul Krugman: “The last slump de facto lasted about 2 1/2 years.
And I don’t see why the same couldn’t happen this time. After all, what’s supposed to take the place of weak housing and consumer spending. Exports, yes — but how much will come, how fast?… The last recession was not, in reality, short — and this one might not be, either” | “Deep? Maybe. Long? Probably…. There’s a huge overhang of excess housing inventory; it will probably take several years before housing prices fall to realistic levels; and it’s not at all clear what will fill the gap left by weak housing and consumer spending. There’s still the question of how deep the slump will be. I can see the case for arguing that it will be nasty. The 1990-91 recession was brought on by a credit crunch, the 2001 recession by overinvestment; this time we’ve got both” |
And you get a very similar vibe from Larry Summers’s speeches at the time:
Lawrence H. Summers: “We are facing the most serious combination of macroeconomic and financial stresses that the United States has faced in at least a generation….
The essential policy problem is to manage a combination of… vicious cycles… the traditional Keynesian vicious cycle… [the] more serious… Liquidation vicious cycle… the Credit Accelerator vicious cycle…. It is a grave mistake to believe in the self-equilibrating properties of the economy or markets in the face of large shocks….
I have talked – and I suspect we will talk later in this conference – of these issues as an abstraction. As a Recession. As a Cyclical Down-Turn. As Declining Asset Values. Make no mistake, there will be millions of people who have never heard of a CDO or a CLO and who think triple A refers to the American Automobile Association, whose lives will be very much affected by the wisdom with which macroeconomic financial policy is made in the weeks and months ahead. The individuals for whom this will be the difference between staying in a home and the humiliation of a Bailiff removing one’s kids from one’s home. The individuals for whom this will be the difference between having a job and not having a job. Between being able to afford to borrow and not being able to afford to borrow. The stakes are not small.
Summers and Krugman were not alone–I remember phone conference calls with Peter Diamond and others, I remember conversations with every single macroeconomist with an office on the southern half of the sixth floor of Evans Hall from David Romer on the east all the way around to Barry Eichengreen on the east–expressed surprise, alarm, dismay, and a great deal of (although clearly not enough) fear. We were arrested by simply looking at the Treasury-Eurodollar spread:
And all of us thought: The TED spread kissed 2% when the crisis broke in the summer of 2007. If your counterparty to whom you have loaned eurodollars doesn’t repay you tomorrow, you will only lose 20% of your money back but that is a scenario in which the need for cash is so dire that that 20% loss is as painful as a 100% loss in normal times. That means that at the odds of August 2007 the market thought that there was one chance in two that one of the ten big banks borrowing that day in the eurodollar market would fail within 30 months.
That’s an extraordinary degree of risk. That means that the market has no confidence in the soundness of the asset base, the leverage structure, or the capital reserves of any of the big money-center banks that are borrowing in the LIBOR market today. And for the market to have so little confidence in the derivatives books of the big money-center banks is horrible news indeed.
That is what macroeconomic theory–the Bagehot-Minsky-Kindleberger variety, at least, that Summers and Krugman and Diamond and Romer and Eichengreen and all the rest of us on th south wall of the sixth floor of Evans Hall were using as our analytical framework–told us. It told us that 2008 was not a time to worry about inflation, but a time to warm up the helicopters, make plans to employ people with shovels, prepare to–if necessary–use Fannie Mae and Freddie Mac to buy up and refinance every single mortgage in the United States, and prepare to–if necessary–use the Fed and the Treasury to support and “resolve” every too-big-to-fail bank
And, of course, we had not seen anything yet:
Thus I read my worthy U.C. Berkeley colleague Neil Fligstein and his coauthors writing:
Neil Fligstein: The Role of “Macroeconomics” as a Sensemaking and Cultural Frame “the Federal Reserve… had surprisingly little recognition that there was a serious financial crisis brewing as late as December 2007…
the inability of the FOMC to connect the unfolding events into a narrative… the housing market, the subprime mortgage market, and the financial instruments being used to package the mortgages into securities. We use the idea of sensemaking to explain how this happened. The Fed’s main analytic framework for making sense of the economy, macroeconomic theory, made it difficult for them to connect the disparate events that comprised the financial crisis into a coherent whole. We use topic modeling to analyze transcripts of FOMC meetings held between 2000 and 2007, demonstrating that the framework provided by macroeconomics dominated FOMC conversations throughout this period. The topic models also show that each of the issues involved in the crisis remained a separate discussion and were never connected together. A close reading of the texts supports this argument. We conclude with implications for future such crises and for thinking about culture and sensemaking more generally…
And my first response is to go all Inigo Montoya on him: “‘Macroeconomic’… I do not think that word means what you think it means…”
The center of gravity of the non-Rosengren non-Yellen Regional Reserve Bank Presidents and the non-Mishkin Republican-worthy Governors was certainly 110% wrong, and completely deaf, dumb, and blind to the situation–but I would not call their conceptual framework a “macroeconomic” one. I am coming to the conclusion that Tim Geithner did not have an analytical framework to understand the situation: if I had to summarize his remarks in the transcripts, it would be: “we have to prevent a total collapse, but we shouldn’t do anything weird”. Ben Bernanke had the conceptual framework for understanding 2007-9 that he had built up over 30+ years as a professor, but he seems to have kept it locked up and in a box.
There was an alarmist wing–and a more correct–wing of the Fed made up of people thinking like macroeconomists: Yellen, Kohn, Mishkin, and Rosengren. It is certainly the case that they did not lay it all out there in the Federal Reserve’s 2008 transcripts, perhaps because of a Fed meeting culture of excessive and counterproductive politeness, perhaps because they were thinking like bureaucratic politician central bankers, perhaps because they were (as I was) confident that the Fed could neutralize any shock a financial crisis threw at it and it was not worth throwing tantrums. (The Greenspan Fed had, after all, successfully managed the financial disturbances of the 1987 stock market crash, the 1990 S&L bankruptcies, the 1994 Mexican shock, the 1997 East Asian crisis, the 1998 Russian bankruptcy, the 1998 LTCM failure, the 2001 dot-com crash, and 911. If those were manageable, why shouldn’t this one be? Certainly that was what I thought.)
But “macroeconomics”–at least what I call “macroeconomics” was not the problem.
David Glasner: Why Fed Inflation-Phobia Mattered: “Last week… I especially singled out
what I called the Gang of Four–Charles Plosser, Jeffrey Lacker, Richard Fisher, and Thomas Hoenig, the most militant inflation hawks on the FOMC–noting that despite their comprehensive misjudgments of the 2008 economic situation and spectacularly wrongheaded policy recommendations, which they have yet to acknowledge, much less apologize for, three of them (Plosser, Lacker, and Fisher) continue to serve in their Fed positions, displaying the same irrational inflation-phobia by which they were possessed in 2008…. The Fed’s inflation-phobia did not suddenly appear at the September 2008 FOMC meeting, or even at the June meeting, though, to be sure, its pathological nature at those meetings does have a certain breathtaking quality; it had already been operating for a long time before that. If you look at the St. Louis Fed’s statistics on the monetary base, you will find that the previous recession in 2001 had been preceded in 2000 by a drop of 3.6% in the monetary base. To promote recovery, the Fed increased the monetary base in 2001 (partly accommodating the increased demand for money characteristic of recessions) by 8.5%. The monetary base subsequently grew by 7% in 2002, 5.2% in 2003, 4.4% in 2004, 3.2% in 2005, 2.6% in 2006, and a mere 1.2% in 2007. The housing bubble burst in 2006, but the Fed was evidently determined to squeeze inflation out of the system, as if trying to atone for its sins in allowing the housing bubble in the first place….
Although the macroeconomic conditions for an asset crash and financial panic had been gradually and systematically created by the Fed ever since 2006, the egregious Fed policy in the summer of 2008 was undoubtedly a major contributing cause in its own right. The magnitude of the policy error is evident in… the dollar/euro exchange rate. From April to July, the exchange rate was fluctuating between $1.50 and $1.60 per euro. In mid-July, the dollar began appreciating rapidly against the euro, rising in value to about $1.40/euro just before the Lehman collapse, an appreciation of about 12.5% in less than two months. The only comparable period of appreciation in the dollar/euro exchange rate was in the 1999-2000 period during the monetary tightening prior to the 2001 recession. But the 2008 appreciation was clearly greater and steeper than the appreciation in 1999-2000. Under the circumstances, such a sharp appreciation in the dollar should have alerted the FOMC that there was a liquidity shortage (also evidenced in a sharp increase in borrowings from the Fed) that required extraordinary countermeasures by the Fed. But the transcript of the September 2008 meeting shows that the appreciation of the dollar was interpreted by members of the FOMC as evidence that the current policy was working as intended! Now how scary is that?
Brad DeLong: Revisiting the Fed’s Crisis: It has been busy days: reading through the transcripts from the 2008 Federal Reserve Open Market Committee meetings in the interstices between pieces of the day job. As I read, I find myself asking the same overarching question: how did the FOMC get into the mindset that it had in 2008?
Oh, there are five voices that seem to me to broadly see and understand the situation. As Jon Hilsenrath of the Wall Street Journal points out, William Dudley’s presentations from the New York Fed’s Markets Group are ideal pieces of bureaucratic staff work that politely and compellingly focus the attention of the principals where it needs to be focused. Janet Yellen from San Francisco, Eric Rosengren from Boston, and Rick Mishkin and Don Kohn from DC and the Board of Governors in Washington clearly get it. But the other members of the FOMC? The rest of the speaking senior staff? Not so much-albeit to greatly varying degrees.
I remember the long history dating back to 1825 and before in which the uncontrolled failure of major banks triggers a flight to quality, asset price collapses, panic, and depression. I contrast that with the FOMC’s mid-September not fear and worry but the self-congratulation by many on the FOMC at having found the strength not to bailout Lehman Brothers–not something I can comprehend. I find myself thinking back to the winter of 2008. I remember how I stole–and used as much as possible–one of Larry Summers’s lines:
In the aftermath of the crash of the housing bubble and the extraordinary losses on derivative securities, banks will have to diminish leverage. While it does not matter much to any individual bank whether it does so by reducing its book or by raising its capital, it matters very much to the economy that the banks choose the second.
In that context, declarations like Tim Geithner’s in March 2008 that “it is very hard to make the judgment now that the financial system as a whole or the banking system as a whole is undercapitalized” and that “there is nothing more dangerous… than for people… to feed… concerns about… the basic core strength of the financial system”–I find those declarations incomprehensible. I look at the long robust and stable time-series history that shows that it is core inflation and not headline inflation that matters for predicting future inflation–even future headline inflation–and declarations like Richard Fisher’s then–and now–that the summer of 2008 saw dangerous inflationary pressure building: I find those declarations similarly incomprehensible. I certainly cannot comprehend them now. And I cannot put myself back into a 2008-era mindset in which I could have comprehended them then.
Some of it–most of it?–is that there are things that are very real and solid to a monetary economist. We can see, touch, and feel how a financial deleveraging cycle depresses aggregate demand; how this year’s change in an inertial price like wages tells you a lot about next year’s wage changes but this year’s change in a non-inertial price like oil tells you next to nothing; how herd behavior by investors means that a single salient bank failure can turn a market from a financial mania into a panic, and then a crash. But others do not see, touch, and fell these things. For non-economists, they are simply ambiguous shadows on the walls of a cave.
The old Federal Reserve had a charismatic, autocratic, bullying, professional central banker at its head: Benjamin Strong, Marriner Eccles, William McChesney Martin, Paul Volcker, Alan Greenspan. When it worked–and it did not always work–the Chair ruled the FOMC with an iron hand and with the near-lockstep voting support of the Governors, and the views of the others with their varying banker, regulator, worthy, and other backgrounds were of little or no account.
The Bernanke Fed has been different. It was collegial, respectful, consensus-oriented.
I think about Ben Bernanke, and about his policy views, and about the analyses he did in the 1980s and 1990s of the Great Depression in the U.S. and of Japan’s “lost decades”. I sense a strong disconnect between the knowledge-base of ex-Professor Bernanke on the one hand and the failure of the 2008 FOMC to sense what was coming down the turnpike and to act to guard appropriately against the major downside risks on the other.
And I find myself wondering: If the Bernanke Fed had been the old Fed–if Rosengren, Yellen, and Mishkin and Kohn on the one hand; and Geithner, Plosser, Fisher, and so forth on the other; had to make their cases to Bernanke in private; and if he had then said “this is what we are going to do” rather than building a within-meeting consensus–would we then have had better monetary policy decisions in 2008?