There is nothing we can do in a macroeconomic sense to repeal economic recession. We can’t do it because it is generally a natural part of a healthy economy to work out changes in patterns of supply and demand.

The part of the latest recession that put the “great” in the Great Recession was largely preventable, however. I don’t disagree that there was a need for imbalances in the housing market to work themselves out. But by the end of the summer of 2007, just after the collapse of Countrywide and various mortgagors in its immediate periphery, most of the financial institutions had organized themselves to be able to withstand a certain amount of associated losses.

Earlier I posted a video from August 2007 of Cramer going bats over Fed inaction. I have also gone through a stack of old “The Economist” magazines I have from the 2007 time frame (when I could still afford to buy them each month). In the back section of these magazines, there is a general market report that has a section about monetary matters. Going through them month by month, starting in about April of 2007 there is an ongoing discussion of how the major central banks have been “sucking liquidity out of the system with no sign of letting up” and that the Fed was promising that it was standing by to act if things got too bad. This kind of report was repeated month after month throughout the year; and interestingly enough, the Fed never did anything even remotely helpful until Bear Sterns found itself in a pile of ultimate trouble in late winter 2008.

Many in the MM (Market Monetarist) circle have been spending an inordinate amount of time explaining how it is nearly impossible for the financial meltdown to have caused the Great Recession and that it is more likely that the Fed caused the financial system implosion with tight money. And I think the reason they get bogged down in this discussion regarding causality time and time again is because after the national psychological trauma of a near complete economic collapse the narrative changed. Everything in the history of the run up to the meltdown chronicled in various publications was somehow vaporized from memory; little symbolic erasers marched on all of the financial chronicles from the prior 18 months and did their dirty work to hide the evidence in plain sight. No one cared what happened before the collapse – they were more interested in what those “naughty bankers” had been doing.

The collapse of Countrywide and possibly Bear, because it sold most of the associated insurance swaps, should have been the end of it and on toward recovery. But because the major central banks kept on “sucking liquidity out of the system,” it was only the beginning of the panic that would rock the entire world while the Fed was washing its hands of the entire affair.

Here’s Governor Mishkin from the fall of 2007 again:

I feel strongly that the one thing a central bank can never afford to do is to lose its nominal anchor.  If we do that, it’s a disaster. With that viewpoint, I should say that, if shocks occurred such that recession was going to occur and the only way we could stop a recession from occurring was to inflate the economy, we couldn’t allow that to happen. We actually have to preserve the nominal anchor because, in the long run, the pursuit of price stability is what makes good monetary policy and has been a key reason for the remarkable success of monetary policy by the central bankers throughout the world in recent years that I think nobody would have predicted.

And I’m going to repeat this part of it again:

…the pursuit of price stability is what makes good monetary policy…

We know by the actual indicators that something strange happened in 2008 that carried forward into 2009. We didn’t get price stability either in the Fed’s formal definition, 2% inflation, or even in a technical sense. If I wanted to be a complete jerk, which I have no problem doing, I would say that once the Fed denies any action that would avoid mass panic, i.e., allows the demand for money or near money to soar without accommodation, price stability is unsustainable and uncontrollable, especially if it knows not where the bottom might be (see my post script). And so the entire statement is an oxymoron, recommending what are the essentials of very bad monetary policy and claiming it is good policy.

I suppose that whether any particular policy is good depends very much on the eye of the beholder and their vantage point, except when compared to the intended purpose of the Federal Reserve. If the purpose of the Fed is not to smooth out the road when necessary adjustments in patterns of supply and demand take place to avoid unnecessary contagion, I can’t imagine what other purpose it might serve and I probably am rather behind on what the intent of “providing an elastic currency” might be.

There is simply no excuse for the Great Recession to have happened in the first place, and no excuse for it continue with no end.

PS: I’ve taken a snippet of from the entry of “Demand for Money” from wiki because I never took the time to digest the formulas for identities:

Importance of money demand volatility for monetary policy

If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have

g_m+g_v=\pi+g_y \,

which says that the growth rate of money supply plus the growth rate of its velocity equals the inflation rate plus the growth rate of real output. If money demand is stable then velocity is constant and g_v=0. Additionally, in the long run real output grows at a constant rate equal to the sum of the rates of growth of population, technological know-how, and technology in place, and as such is exogenous. In this case the above equation can be solved for the inflation rate:

\pi=-g_y+g_m \,

Here, given the long-run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. In this case inflation in the long run is a purely monetary phenomenon; a monetary policy which targets the money supply can stabilize the economy and ensure a non-variable inflation rate.

This analysis however breaks down if the demand for money is not stable — for example, if velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of targeting interest rates rather than the money supply can improve upon this outcome as the money supply is adjusted to shocks in money demand, keeping interest rates (and hence, economic activity) relatively constant.

The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the LM curve, then a policy of targeting the money supply will be destabilizing.

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