What if the Federal Reserve Had Listened to the BIS?

What do you get when the key insights of Hyman Minsky--prolonged macroeconomic stability can actually be destabilizing if it causes observers to take for granted the "good times" and underestimate risk going forward--and Frederick Hayek--price stability is not a sufficient condition for macroeconomic stability--are accepted by a group of mainstream economists? You get economists who were able to foresee as early as 2003 the current economic crisis and issue a warning. And just who are these economists? They are the research staff at the Bank for International Settlements (BIS), formerly led by William White. Der Spiegel has a great article on William White and his colleagues that highlights how they repeatedly warned central bankers of the dangers lurking ahead but to no avail. What is amazing, is that the BIS is the bank for central banks and had the ear of Alan Greenspan and other central bankers. In other words, these were not a bunch of economic cranks, but serious research economists at a top economic institution who were given a hearing but ignored by top policymakers. Here is Der Spiegel:

[William] White and his team of experts observed the real estate bubble developing in the United States. They criticized the increasingly impenetrable securitization business, vehemently pointed out the perils of risky loans and provided evidence of the lack of credibility of the rating agencies. In their view, the reason for the lack of restraint in the financial markets was that there was simply too much cheap money available on the market. To give all this money somewhere to go, investment bankers invented new financial products that were increasingly sophisticated, imaginative -- and hazardous.

As far back as 2003, White implored central bankers to rethink their strategies... The prevailing model [at central banks] was banal: no inflation, no problem. But White wanted central bankers to take things a step further by preventing the development of bubbles and taking corrective action. He believed that interest rates ought to be raised in good times, even when there is no risk of inflation. This, he argued, counteracts bubbles and makes it possible to lower interest rates in bad times. He also advised the banks to beef up their reserves during a recovery so that they would be in a position to lend money in a downturn.

William White and his crew took this message directly to key players time and time again. Among other publications, they did so with this paper presented at the Fed's Monetary Policy symposium at Jackson Hole Wyoming in August 2003 (Greenspan was in attendance), as well with this paper titled "Is Price Stability Enough" in 2006, and in many of the popular BIS Annual Reports. My favorite article of the bunch is the second one above which happens to have been written by White himself. Here are some excerpts:

It will be argued in this paper...that achieving near-term price stability might sometimes not be sufficient to avoid serious macroeconomic downturns in the medium term. Moreover, recognising that all deflations are not alike, the active use of monetary policy to avoid the threat of deflation could even have longer term costs that might be higher than the presumed benefits. The core of the problem is that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms – whether in terms of debt levels, saving ratios, asset prices or other indicators of “imbalances”. The historical record indicates that mean reversion is a common outcome, with associated and negative implications for future aggregate demand.

[...]

One implication of positive supply side shocks is that they call into question whether monetary policy should continue to pursue the near-term [monetary policy] target of a low positive inflation rate... Failure to adjust the [monetary policy] target downward (whether explicitly or implicitly) in the face of positive supply shocks would result in lower policy rates than would otherwise be the case... Paradoxically, taking out insurance against a benign deflation might over an extended period increase the probability of the process eventually culminating in a “bad” or even “ugly” one.

This is the same point I have made here on this blog: by avoiding the benign deflationary pressures of 2003 the Fed help put in motion the developments that created the malign deflationary pressures of 2009. If only the folks at the BIS had been taken more seriously. One can only imagine how different the current economic crisis would have been.

Another Way to View the Crisis: A Boom-Bust Cycle in Global Nominal Spending

Many observers, including myself, have spent many hours thinking about the source of the current economic crisis. Much of the discussion in this debate has centered on the role played by the list of suspects rounded up so far: a saving glut in emerging economies, excessive fiscal and monetary policy stimulus in advanced economies, the securitization of finance, underestimating aggregate risk, the lowering of lending standards, the failings of rating agencies, aggressive lending tactics, and poor choices made by lenders. The truth is some mix of all of these played a role. That makes it difficult to apportion responsibility (or blame) accurately and, thus, makes it challenging to draw the appropriate lessons from this crisis moving forward. So in an attempt to simplify matters, this post presents the economic crisis from a different perspective.

So what is this perspective? This approach begins with the understanding that the key to macroeconomic stability--whether nationally or globally--is to stabilize nominal spending. If an economy is running near full employment, then any sudden increase or decrease in nominal spending will give rise to changes in real economic activity that fall outside its natural rate area (i.e. is unsustainable). Why? Because there are numerous nominal rigidities that prevent prices from adjusting instantly. There is simply no way to suddenly jar nominal spending and not have real economic activity move as well. Note, that key here is not to aim for price stability, but to aim for nominal spending stability. As I noted before,

Nominal spending shocks, after all, are the real source of macroeconomic volatility while inflation is merely a symptom of these shocks. Moreover, inflation can sometimes can be hard to interpret--Is the high(low) inflation due to positive(negative) aggregate demand shocks or negative(positive) aggregate supply shocks?--and as a result monetary policy that targets inflation may make the wrong call.

Now apply this thinking to the global economy. From 1980-2002 global nominal spending (as measured by world nominal GDP) in current U.S. dollars grew about 5.0% a year. In PPP current international dollars it grew 6.1% a year. Suddenly, in the period 2003-2007 those numbers jumped to 10.7% and 7.5%. (Data from WEO databse April 2009.) This surge in global nominal spending was sudden and most likely unexpected given the trends for the 1980-2002 period. These developments can be seen in the figure below: (Click on figure to enlarge.)

In short, the world experienced a nominal spending boom over the years 2003-2007 that was unsustainable. Today, the excesses related to that boom are being worked out.

Now why bring up this perspective? Because I believe it has clear policy implications: policy makers should be watching nominal spending both at home and across the globe. Focusing too narrowly on inflation caused policymakers to miss this surge in nominal spending. Two institutions in particular should be watching global nominal spending. First, the IMF should be monitoring global nominal spending given its objectives for global financial stability. Second, the Federal Reserve should also be closely monitoring global nominal spending because (1) it is a monetary superpower and can currently shape to some degree global nominal spending and (2) it has also an enhanced mandate for financial stability. Stabilizing global nominal spending will not eliminate all financial risk, but it will go along way in preventing the buildup of economic imbalances.

Assorted Musings

More assorted musings:

1. The saving glut smackdwon continues. First Menzie Chinn dealt it a back-breaking blow, then I pounded it with some monetary superpower, and now Asian officials are pushing back as well.
2. Apparently the Swedish central bank has been reading Scott Sumner's blog. They are now penalizing banks for holding excess reserves. This move is a part of a package where they are effectively cutting interest rates to minus 0.25 percent.
3. Josh Hendrickson has a great post where he reminds us that yes, "inflation is a monetary phenomenon, but this isn't inflation." I hold a similar view.
4. Nick Rowe baits me in for more discussion on whether the Fed actually pushed its policy rate below the natural interest rate in the early-to-mid 2000s. I am convinced it did, Nick is not so sure. See our exchange in the comment's section.
5. Speaking of the natural interest rate here is a graph from an ECB paper that rigorously shows the actual interest rate (red line) did drop below the natural interest rate (black line). Click on figure to enlarge.
6. Here is a great article on Mark Thoma and how he influences the national debate through his blog the Economist's View. The economic blogosphere really has become a force in shaping economic policy. I had a conversation about this with Tyler Cowen and he pointed to, among other things, how the original plans for the TARP were scrapped because of negative feedback from the blogosphere.
   

Yes Brad, the Fed's Low Interest Rate Policy Was a Mistake

Brad Delong is wondering whether the Federal Reserves' low interest rate policy in the early-to-mid 2000s was truly a mistake:

There is, however, active debate over whether there was a fourth mistake: whether Alan Greenspan's decision in 2001-2004 to push and keep nominal interest rates on Treasury securities very very low in order to try to keep the economy near full employment was a fourth mistake...I am genuinely not sure which side I come down on in this debate.

Brad's uncertainty is understandable given he invokes the entire 2001-2004 time frame. For during this period there was a time when the U.S. economic recovery was sputtering along (2001-2002) and a time when the recovery began to take hold (2003-2004). It was during this latter period that Fed's low interest rates were a big mistake. But even for that period I think Brad is misreading the data:

People claim that the Greenspan Federal Reserve "aggressively pushed the interest rate below its natural level."... [T]he market interest rate[, however,] was if anything above the natural interest rate in the early 2000s: not accelerating inflation but rather deflation threatened. The natural interest rate was very low because, as Ben Bernanke explained at the time, the world had a global savings glut (or, rather, a global investment deficiency). You can argue--and on Tuesdays and Thursdays I will believe you--that Alan Greenspan's policies in the early 2000s were wrong. But you cannot argue that he aggressively pushed the interest rate below its natural level. The low interest rate was at its natural level.

I think the evidence shows the opposite. The natural interest rate is a function of individual's time preferences, productivity, and the population growth rate. Of these three components, the one that changed the most in 2003-2004 was productivity as can be seen in the figure below (click on figure to enlarge):


Here we see productivity growth soaring just as the real federal funds rate is being pushed into negative territory. Normally, a rise in productivity growth should lead to a rise in the natural interest rate and ultimately, a rise in the federal funds rate for monetary policy to stay neutral. However, this latter development did not happen. It seems, then, the Fed did push its policy rate below the natural rate and in the process created a huge Wicksellian-type disequilibria. This interpretation of events has been borne out more rigorously in this ECB paper. One a more practical level, this disequilbria comes through in the Taylor rule which similarly shows the federal funds rate was below the neutral rate during this time.

It is also worth noting that these same rapid productivity gains were the source of the deflationary pressures in 2003 that Brad mentions. Thus, these deflationary pressures did not indicate a weakening economy. In fact, aggregated demand (AD) was growing at at rapid rate in 2003-2004 which, if anything, indicated an overheating economy. The figure below shows a measure of AD, final sales to domestic purchasers, relative to the federal funds rate and has the period 2003-2004 marked off by the dotted lines (click on picture to enlarge):


The productivity gains, apparently, were offsetting the upward pressure on prices being created by the robust growth in AD at this time. There simply was no real deflationary threat in 2003. By way of contrast, this figure shows for 2008-2009 what a real AD-induced deflationary threat looks like. Regarding the saving glut theory I would recommend Menzie Chinn's post here or my previous post here.

The final data issue is the weak employment growth coming out of the 2001 recession. Given the above discussion, the best interpretation of this development is there was less demand for labor in the recovery given the productivity gains. In fact, this was common explanation given at the time. One could also argue that the Fed's low interest rate policy may have pushed some firms to inordinately substitute out of labor to capital.

Here is the bottom line: there is enough evidence for Brad DeLong to conclude that Federal Reserve's low interest rate policy was a mistake.

Update: Brad DeLong responds to this and other posts.

Saving Glut Smackdown

The Saving Glut theory of the buildup of global economic imbalances and its application to the current economic crisis has been a popular story ever since it was introduced by Ben Bernanke. Menzie Chinn, however, has dealt a serious critique to this view that probably will be followed by others as time goes on. His view is that the Saving Glut (1) should be put to rest as an idea, (2) is mostly a mirage of the data, and (3) did not cause the current economic crisis. I agree with most of what Chinn says in this critique. I would note, however, that some of the key problems with the Saving Glut theory occur because the role of U.S. monetary policy is not properly accounted for in the analysis. Here are the problems:

(1) The Saving Glut theory has an underlying theme of inevitability. The implicit message is that the U.S. was destined to be a profligate spender because of the huge CA surpluses in Asian and oil-exporting countries. Really? Were U.S. policymakers truly constrained by the whims of foreign savers?

A key reason why this inevitability view is suspect is that it ignores a key fact: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

What is interesting is that many advocates of the saving glut view who argued the U.S. had to run a current account deficit in the early-to-mid 2000s to accommodate the current account surpluses elsewhere in the world later argued in the middle of 2008 that loose U.S. monetary policy was being exported abroad creating too much stimulus in the dollar bloc countries. In other words, these observers had somehow gone from a world where the Fed is a slave to the dollar block countries to a world where the dollar block countries are a slave to the Fed. For example, here is Martin Wolf who argued early on the inevitability of U.S. current account deficits but then had this to say in June 2008:

To simplify, Ben Bernanke is running the monetary policy of the People’s Bank of China. But the policy appropriate to the US is wildly inappropriate for China and indeed almost all the other countries tied together in the informal dollar zone or, as some economists call it, “Bretton Woods II”.

Thus, not only have the imbalances proved hugely destabilising in the past, but they are going to prove even more destabilising now that the US bubble has burst. When most emerging economies need much tighter monetary policy, they are forced to loosen still further.

To be fair, Martin Wolf has since come to acknowledge the U.S. monetary policy played a role. But the point is clear: if the Fed was a monetary hegemon in 2008 then it was also one in the early-to-mid 2000s. It could have tightened policy then and prevented some of the saving glut.

(2) Long-term interest rates were going down across the globe. The saving glut, however, was regionally based in Asian and oil-exporting countries and mostly went to a regionally-based saving deficit area, the United States. How, then, could a regional saving glut cause global long-term rates to decline? (This is why the saving glut explanation for the interest rate conundrum in 2005 is far from satisfactory.) An easier explanation is that Fed's low interest rates in the early-to-mid 2000s were exported across the global economy as described in (1) and transmitted to long-term rates via the expectation hypothesis of the term structure of interest rates.

(3) If the huge CA surpluses in Asian and oil-exporting countries did, in fact, lead to the lowering of long-term rates in the U.S., which in turn fueled the housing boom, why did long-term rates start rising in 2006? How is that the saving glut could fuel low rates in the early-to-mid 2000s but not thereafter? See the figure below (click on figure to enlarge):

(4) Finally, close to 40% of mortgages issued at the height of the housing boom were either subprime or Alt-A. Unlike traditional long-term, fixed-rate mortgages these other type of mortgages had financing charges tied to short-term interest rates . The Fed controls short-term interest rates. The saving glut story typically focuses on the long-term rates. As Larry White notes, the Fed's policies clearly were the big factor here.

To be clear, I do believe this crisis was more than just poor choices made by U.S. policymakers. The securitization of finance, underestimating aggregate risk, the lowering of lending standards, rating agencies failing, aggressive lending tactics, and poor choices made by lenders all contributed to the current economic crisis. However, the Fed's monetary policy choices in the early-to-mid 2000s was in my view key to making these other developments more distortionary and its role helps shed light on the problems with Saving Glut view.

What Happened to Private Sector Job Growth?

That is the question I had after reading Michael Mandel's article on the declining private sector job growth over the past decade. Here is the money graph (click on figure to enlarge):


Mandel goes on to show that most of the employment growth came from government or government-supported private sector jobs. Wow!

The Economist Magazine on Church Attendance During the Recession

The Economist's magazine is reporting on how the recession is affecting church attendance and more-or-less concludes there is no evidence of a link. The article, however, has a number of problems. Let me begin with this paragraph:

Last year David Beckworth, an assistant professor of Economics at Texas State University, examined historic patterns in the size of evangelical congregations and found that, during each recession cycle between 1968 and 2004, membership of evangelical churches jumped by 50%. This report filled the newspapers and TV news-shows at the height of the depression panic just before Christmas; but the report’s findings focused on evangelicals, and do not apply to Americans at large.

I did not find membership jumps by 50% during recessions, rather the membership growth rate jumps by that amount. Moreover, while that 50% bump in the growth rate applies only to evangelicals this finding was only part of my study. In fact, the first part of my paper uses a national Pew Survey taken in November 2001 to see if after controlling for evangelicals, 911, and a host of other confounding factors whether one's employment status affects the likelihood of weekly attendance. I found that being unemployed did increase weekly religious attendance in a statistically significant manner.

What my findings show is that one cannot look at the national average and determine if the recession is affecting religious attendance; one has to look at those folks who have been adversely affected the recession to make that call. Frank Newport and the folks at Gallup seem to miss this point. They only look at the headline number and never dig deeper. Gallup simply is not looking at the right data to answer this question. I have not seen John Green's work from Pew Forum on Religion and Public Life, but I suspect he too is looking at the headline weekly attendance number only. I would encourage Frank Newport, John Green, and other interested observers to take a look at my entire paper here.

What makes this frustrating is that I made this point to the Economist's correspondent who contacted me about this story. I have also contacted the folks at Gallup on this same issue back when this issue came up late last year.