In looking through some of my old posts, I found this one that features a quote from Milton Friedman in Capitalism and Freedom regarding the appropriateness of a price stability mandate, and I thought I would take a dive into explaining my perspective of the cause of the Great Recession, why a price stability mentality is harmful, and why nearly everything we’ve heard regarding the cause and prevention measures is wrong.
Here is the quote from Friedman again:
If a [monetary policy] rule is to be legislated, what rule should it be? The rule that has been most frequently suggested by people of a generally [neo-] liberal persuasion is a price level rule; namely a legislative directive to the monetary authorities that they maintain a stable price level. I think this is the wrong kind of rule. It is the wrong kind of rule because it is in terms of objectives that the monetary authorities do not have the clear and direct power to achieve by their own actions. It consequently raises the problem of dispersing responsibilities and leaving the authorities too much leeway. There is unquestionably a close connection between monetary actions and the price level. But the connection is not so close, so invariable, or so direct that the objective of achieving a stable price level is an appropriate guide to the day-to-day activities of the authorities.
Friedman advocated a monetary base growth rule as a substitute for a price stability mandate at the time Capitalism and Freedom was written; the basis of the preference being that the elasticity of the monetary base is the only thing that is within direct control of monetary authorities. He believed that something like a monetary base growth rule would prevent overt commission of episodes of monetary contraction and expansion that foisted wild effects of extremes on the public, from Great Depression-like deflation to 1970’s-style inflation.
Regardless of whether his prescription was a good fit, the point that the base is the only thing that is within direct control of the central bank is valid and universal, and it serves as a level setting tool to avoid cognitive illusions regarding the primacy of inflation and interest rates in determining the stance of monetary policy and in the foundational mechanics of the macro economy. In normal times, the short term interest rate peg is accomplished through changes in the monetary base. But the use of a nominal interest rate peg is not the only way to conduct policy nor should it be.
The problem with a fixed monetary base growth rule is that it ignores macroeconomic realities to a large extent and does not avoid potential problems of supply shocks impacting the demand for money. Thus, it would not have prevented the Great Recession and would not have been amendable to produce a recovery from a recession that was caused by an unusual and immediate increase in the demand for money.
A price stability mandate is unamendable in nearly the same way, though in a cognitive sense as monetary authorities are focused on inflation and reading tea leaves regarding where it might go as macroeconomic realities cause the demand for money to outstrip supply; and unmet demand for money tends to multiply until satisfied on the margins.
The graph below shows the approximate coup de grace that turned a garden variety recession into the worst financial disaster in generations, and creates a poster child of the cognitive dangers of price stability mandates in general, and explicit inflation targeting in particular. It illustrates the inelasticity of holdings of the Federal Reserve from 2007-2009 in which Treasury securities were swapped for increased lending to financial institutions, presumably to avoid impacting inflation. In simple terms, it means that as the general demand for liquidity was increasing as investors were heading for the exits, the Fed was sopping up available liquidity and transferring it to firms that were experiencing immediate stress, causing otherwise healthy firms and individuals to become liquidity-starved, and otherwise good loans to go bad. Because inflationary pressures are not caused by the creation of base relative to base in existence, but relative to the demand for money (MV=PY), this operation was highly contractionary despite dramatic cuts in the Federal Funds rate in early 2008. It is nothing short of cognitive dissonance for the assumption to have been made that in an environment of market driven credit contraction that bank lending could satisfy liquidity needs with the primary indicator being that banks themselves were under stress. Thus, this is a picture of lack of amenability of a single-minded focus on mapping CPI measures directly to monetary response and discretionary Fed behavior that is highly irresponsible – a horror beyond description.
It could be simply described as reallocation of static resources by the Fed that is comprehended and predicted to result in a nominal shock by many different schools of economic thought. One does not have to subscribe to monetarism to understand this; and it is surprising to me, though not particularly versed in the customs and traditions of the economics profession, that there is volumes of misinformation regarding the cause of the financial crisis and the Bernanke Fed has largely escaped due public scrutiny in the matter.
Popular conflation of causality of the Great Recession into one element, namely excesses in housing and related derivatives, is a source of much public confusion and misdirection in my opinion. There are two distinct events in the formation of the Great Recession: 1) the housing correction and 2) mistakes made by the Federal Reserve in conduct of monetary policy that were compounded by more mistakes during the correction. The correction of housing and related excesses lead to economic slowing in 2006 which was largely contained until late summer of 2007 when the Fed, focused on headline inflation from increases in energy costs, raised the Fed funds rate and signaled that more increases were on the way. Some of my blogger friends differ in respect to which mistakes in conduct of monetary policy lead to the Great Recession and when they were actually made, but I tend to believe it was at the September 2007 FOMC meeting. I am not asserting that the Great Recession was inevitable at that point. But that mistake exacerbated the housing correction and lead to the following contagion by contributing to the increase in the demand for money as credit was contracting. The recession became inevitably severe when the increased lending to firms that were under stress was sterilized, doing nothing to satisfy the excess demand for liquidity from both the housing correction in addition to the contagion. It is not different in basic effect, the creation of one or more nominal shocks, than the wholesale refusal to prevent bank runs against an inelastic commodity standard in the 1930’s.
Even if one believes wholeheartedly that “artificially low interest rates” caused excesses in housing, that point is irrelevant to the ultimate size and scope of the recession. It did not have to become severe or persistent. And I sincerely believe that the public good has not been nor would be served by monetary measures that are intended to restrict access to or increase the cost and risks involved in the use of credit because they simply do not address the potential for severity of any future recession. All recessions are potentially damaging to the same extent, the absolute difference in the most severe cases in recent history involved monetary mistakes that persisted until the political system forced change. And if we do not wish to go through this again, perhaps much sooner than 85 years given the present state of monetary disarray, the right lessons need to be learned and the right problems need to be addressed.