The Same Thing Causing The Slow Recovery Also Caused The Recession

by: Scott Sumner

Saturos and Johnleemk sent me an excellent speech by William Dudley of the NY Fed. As usual I'll start by nitpicking, but then end on a positive note:

In my view, the primary reason for the poor performance of the U.S. economy over this period has been inadequate aggregate demand. There are several explanations for this. Although some were well-known earlier, others have only become more obvious as the recovery has unfolded. . . .

During the credit boom, finance is available on easy terms and the economy builds up excesses in terms of leverage and risk-taking. When the bust arrives, credit availability drops sharply and financial deleveraging occurs. Wealth falls sharply, precautionary liquidity demands increase, desired leverage drops further. . . .

When the bust arrives, over-indebted households and businesses want to increase their saving and liquidity buffers, and financial intermediaries want to raise credit standards. Both responses restrain demand and make a cyclical rebound more difficult.

The Fed's job is to determine AD, so I'm glad to see they are taking some responsibility for the slow recovery. But do you notice something missing? He talks about the "bust" and then the slow recovery, but there is no mention of the recession. What happened to the great RGDP and NGDP crash of June through December 2008? Many people think that was the "bust." Nope, the housing bust of January 2006 to April 2008 had virtually no impact on the US unemployment rate. Then unemployment soared when NGDP collapsed, not in the earlier 27 month period when housing construction crashed and banks tightened lending standards. In mid-2008 economists weren't even predicting a sharp rise in unemployment for 2009, even though the "bust" was fully understood. Dudley continues:

In the U.S. case, because the bust was concentrated in housing, the scope for a strong cyclical recovery was particularly constrained because the interest-rate sensitive sector that would typically lead such a rebound could not recover until the overhang of unsold homes and the impairment of housing finances was corrected.

Nope. The steep June 2008 to December 2008 RGDP crash was caused by a huge drop in non-housing output, and hence housing in no way restrained the recovery. Housing was completely in the toilet in April 2008 and unemployment was still only 4.9%. All we needed to do to recover was to get NGDP up to a level where the other industries returned (in aggregate, not individually) to April 2008 levels. Dudley is still misdiagnosing the crisis, and hence not putting enough blame on the Fed for the slow recovery.

The U.S. recovery has also been subpar because it has been taking place in the context of a weak global economy.

That's true, but not a major problem for a big economy like the US. Stimulus here would change the entire global outlook.

After all, on the other side of the ledger, the policy response following the crisis has been much more aggressive than is typical. On the monetary policy side, the Federal Reserve cut short-term interest rates close to zero, communicated that short-term rates were likely to stay exceptionally low far into the future, and undertook a series of large-scale asset purchases in order to ease financial conditions further.

Yes, but these things should have been done before or during the Great NGDP Crash. Instead the Fed didn't cut rates to zero until (according to monthly data from Macroeconomics Advisers) the Great NGDP Crash was essentially over. By then the economy was very weak, credit demand was extremely low, and far more aggressive monetary stimulus was needed.

Dudley then discusses 4 factors that slowed the recovery, before getting to the key factor:

I would give each of these four explanations some weight for why the recovery has been consistently weaker than expected. But I would add a fifth, monetary policy, while highly accommodative by historic standards, may still not have been sufficiently accommodative given the economic circumstances.

Translation: Sumner and the other market monetarists were right in 2008-09, and we at the Fed were wrong. Was I right because I'm a genius? Clearly not. Am I like the broken clock that's right twice a day? Maybe, but then explain why at no time in my life did I ever call for much easier money, until late 2008. I'm a Chicago-trained inflation hawk. Luck? Or as Krugman would say, the right model? It turns out that it was blindingly obvious money was too tight, because the markets were screaming for easier money. It's just that no one (except Cramer on Mad Money) seemed to notice.

[I wish someone could find a Youtube of Cramer blowing his top in late 2008, when the BOE cut rates and gave hope to the markets, and then the ECB dashed the hopes by doing nothing a few hours later.]

My conclusion is that the easing of financial conditions resulting from non-traditional policy actions has had a material effect on both nominal and real growth and has demonstrably reduced the risk of particularly adverse outcomes. Nevertheless, I also conclude that, with the benefit of hindsight, monetary policy needed to be still more aggressive. Consequently, it was appropriate to recalibrate our policy stance, which is what happened at the last FOMC meeting.

I get shivers down my spine (in a good way) when any VIP uses the term 'nominal growth.'

As I argued in a recent speech, simple policy rules, including the most popular versions of the Taylor Rule, understate the degree of monetary support that may be required to achieve a given set of economic objectives in a post-financial crisis world. That is because such rules typically do not adjust for factors such as a time-varying neutral real interest rate, elevated risk spreads, or impaired transmission channels that can undercut the power of monetary policy.

Yup, and the markets know best what sort of policy is needed.

However, policymaking is about making choices between available alternatives. In the long run, even savers would be better off in a world in which aggressive monetary policy generates a strengthening recovery that eventually permits the normalization of interest rates, than they would be compared to a circumstance in which the United States allowed itself to fall into a Japan-style trap of low growth and low rates for decades. So I do not view the effect of low rates on savers as a reason to be less accommodative.


I've covered on a few areas where I slightly disagree. But the paper is full of very wise comments about the interaction of structural changes and monetary policy. I strongly agree with most of Dudley's observations. Read the whole thing.

PS. In some respects the Board of Governors actually has 8 members, as the New York Fed president always votes on the FOMC. Good to know the NY Fed president is Dudley. Now that Kocherlakota has flipped, I'm pretty sure we'll never see more than 2 hawks on the FOMC at any one time.

Yes Romney (in the unlikely event he's elected) may get rid of Bernanke. But he secretly supports Bernanke's policy, and indeed publicly supported it until the entry of Fed-bashing Rick Perry threatened his path to the nomination. That's why Romney would not appoint Taylor to be Fed chief, he'd fear that another 1937 would cost him re-election. It would be Greg Mankiw, and the Bernanke policy would be continued.