Just as the 1929 stock market crash didn’t cause the Great Depression, the housing collapse didn’t cause the Great Recession. In both cases, monetary policy mistakes were the likely proximate and fundamental cause. The role of the Federal Reserve in the Great Depression was the subject of Milton Friedman and Anna Schwartz’s A Monetary History of the United States. The Fed’s role in causing the Great Recession and Financial Crisis is explained in The Great Recession: Market Failure or Policy Failure? by Robert Hetzel. The first book caused a major rethink in the economic profession, so should the second. As Hetzel puts it: “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”
I have written a number of blog posts on this topic. But Ramesh Ponnuru gives a great overview on the theory in his wonderful new National Review story, “Cause for Depression.” Although the housing slump began in mid-2006, the economy actually weathered the decline quite well until 2008. The following two charts show housing prices and starts vs. the unemployment rate:
Ponnuru picks up the story:
One way monetary policy affects the economy, and arguably the crucial way, is by shaping expectations. When the Fed creates an impression about future spending levels, it affects the spending that people undertake today in anticipation of that future. So when the Fed suggests that it will pursue a tighter policy in the future, it is effectively tightening money in the present. Even when it cuts the federal-funds rate, it may be tightening money if markets had projected a sharper cut.
By mid 2008 the Fed had been effectively tightening for months. In December 2007 the Fed cut the federal-funds rate by less than markets had expected. During the summer Fed officials made inflation-phobic comments that led informed market participants to expect a tighter policy in the future. The minutes of the August 2008 meeting declared that “members generally anticipated that the next policy move would likely be a tightening.” Current policy was “passively” tightening as well: As the economy deteriorated, the distance between the looseness it needed and what the Fed was providing increased.
Even after Lehman Brothers collapsed in September 2008, the Fed refused to cut the federal-funds rate and issued a statement citing the risks of inflation. Market expectations of inflation fell further. The Fed would not cut rates until October 8, weeks after the crisis had started to dominate the news — and even that decision followed a contractionary move, the October 6 decision to pay banks interest on excess reserves, which discouraged bank lending.
Markets had no reason to have any confidence that the Fed would continue to keep total spending throughout the economy rising at a steady rate, as it had more or less done for the previous quarter-century. Indeed, spending started to fall in June 2008, months before Lehman’s collapse, and ended up declining at the fastest rate since “the recession within the Depression” of 1937–38. Tight money — that is, reduced expectations of future spending — made everything worse. It depressed asset prices and raised debt burdens, adding to bank losses and making households more fearful about spending.
Which is why some folks call the Great Recession “Bernanke’s Little Depression.” While the Bernanke Fed should get much credit for being as active as it was once the economy collapsed — especially compared to the European Central Bank — it could and should have done more, as Ponnuru adds: … “very tight money led first to a financial crisis and then to a slow recovery.”
Now, this is an extremely inconvenient narrative for those blaming the Great Recession on a free-market failure as a way of pushing for more government regulation and control in all aspects of the economy. And while it may also be how most Americans view the Great Recession, pro-market advocates should nevertheless try and set the record straight.