Nearly a decade after the financial crisis and Great Recession began, scores of arguments about the cause of the financial crisis continue to rage. I have to admit that I have been party to, and equally distracted by, discussions about what caused the perception of a housing bubble in the early to mid-2000’s, whether one ever existed at all, and whether the subsequent bust was a form of just deserts.
While these are important discussions to have, reasonable people can argue forever about the causes of the calamity without ever arriving at a conclusion about what sorts of policy prescriptions constitute reasonable policy responses, which are even more important because it speaks to what we might do as a matter of policy that impacts nearly every aspect of life that has to do with money, from mere survival to making and keeping large amounts of it.
To follow the “too low for too long” narrative, against a backdrop of low interest rates and easy money, people used credit like never before, household debt levels breached previous records and kept going – Joe Public really gorged on stuff via home equity loans, creating so much demand that it fed inflation, and inflation became a serious problem.
Supposing I conceded the argument for the sake of getting to the more important part of the conversation of what an appropriate response to this issue should have been, my view is that past easy money almost never constitutes the need for a Volker-style disinflation (for the record, I don’t believe it was necessary when Volker did it), and the Fed forecasts of mildly elevated PCE inflation did not justify the policy response that was implemented as raising the FF rate from 0.75 to 6.25 between 2006 to 2007. The immediate post tightening cycle scenario where short nominal rates were reduced to 2 percent and then finally to the ZLB in 2008 indicates that the Fed previously went too high, too fast and was subsequently reluctant to move fast and far enough to reverse its mistake (all with some degree of levity, mind you).
Given the state of household debt levels at the time, the policy response to headline inflation data can be accurately described as not only draconian, but irresponsible – with a full employment and price stability mandate, a past easy money sensation that comes from a positive nominal shock requires restoration of nominal stability, resumption and maintenance of a neutral policy stance from that point forward with inflation drifting down toward the target over time, not aggressive tightening that creates a negative nominal shock of equal or greater magnitude that comes with the all of impact implied. The chosen response was not adherence to price stability and it was madness.
If we could at least agree in principle that an acceptable and appropriate monetary policy response to a perception of easy money isn’t to throw the baby out with the bathwater and do more harm than temporarily elevated PCE inflation (and standing armies) would, it would be a huge step toward making the world a much better place than it is now. At least, that is all I really want out of the ongoing discourse, and the largest portion of my beef with the profession in general and monetary policy bureaucrats in particular would then simply disappear, restoring some degree of tranquility and normalcy to what has otherwise been a decade of fear, cynicism and instability that we all wish had been over with long ago. In other words, I don’t care at which alter they choose to worship; if it does no harm, it’s not worth arguing about.