THE GREAT RECESSION Since publication of Robert L. Hetzel’s e Monetary Policy of the Federal Reserve (Cambridge University Press, 2008 ), the intellectual consensus that had charac- terized macroeconomics has disappeared. at consensus emphasized e cient markets, rational expectations, and the e cacy of the price system in assuring macroeconomic stability. e 2008–2009 recession not only destroyed the pro- fessional consensus about the kinds of models required to understand cyclical uctuations but also revived the credit-cycle or asset-bubble explanations of recession that dominated thinking in the nineteenth century and rst half of the twentieth century. ese “market-disorder” views emphasize excessive risk taking in nancial markets and the need for government regulation. e pres- ent book argues for the alternative “monetary-disorder” view of recessions. A review of cyclical instability over the last two centuries places the 2008–2009 recession in the monetary-disorder tradition, which focuses on the monetary instability created by central banks rather than on a boom-bust cycle in nan- cial markets. Robert L. Hetzel is Senior Economist and Research Advisor in the Research Department of the Federal Reserve Bank of Richmond, where he participates in debates over monetary policy and prepares the bank’s president for meetings of the Federal Open Market Committee. Dr. Hetzel’s research on monetary pol- icy and the history of central banking has appeared in publications such as the Journal of Money, Credit, and Banking; the Journal of Monetary Economics ; the Monetary and Economics Studies series of the Bank of Japan; and the Carnegie- Rochester Conference Series . His writings provided one of the catalysts for the congressional hearings and Treasury studies that led to the issuance of Treasury In ation Protected Securities (TIPS). Dr. Hetzel has given seminars or served as a visiting scholar at the Austrian National Bank, the Bank of England, the Bank of Japan, the Bundesbank, the European Central Bank, the National Bank of Hungary, and the Center for Research into European Integration in Bonn, Germany. He received his PhD in 1975 from the University of Chicago, where Nobel Laureate Milton Friedman chaired his dissertation committee. Dr. Hetzel is author of e Monetary Policy of the Federal Reserve (Cambridge University Press, 2008 ). Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Studies in Macroeconomic History Series Editor: M i c h a e l D . B o r d o , Rutgers University Editors: M a r c F l a n d r e a u , Institut d’Etudes Politiques de Paris Chris Meissner , University of California, Davis F r a n ç o i s V e l d e , Federal Reserve Bank of Chicago David C. Wheelock , Federal Reserve Bank of St. Louis e titles in this series investigate themes of interest to economists and economic historians in the rapidly developing eld of macroeconomic history. e four areas covered include the application of monetary and nance theory, international economics, and quantitative methods to historical problems; the historical application of growth and development theory and theories of business uctuations; the history of domestic and international monetary, nancial, and other macroeconomic institutions; and the history of international monetary and nancial systems. e series amalgamates the former Cambridge University Press series Studies in Monetary and Financial History and Studies in Quantitative Economic History . Other books in the series: H o w a r d B o d e n h o r n , A History of Banking in Antebellum America [9780521662857, 9780521669993] M i c h a e l D . B o r d o , e Gold Standard and Related Regimes [9780521550062, 9780521022941] Michael D. Bordo and Forrest Capie (eds.), Monetary Regimes in Transition [9780521419062] Michael D. Bordo and Roberto Cortés-Conde (eds.), Transferring Wealth and Power from the Old to the New World [9780521773058, 9780511664793] Michael D. Bordo and Ronald MacDonald , Credibility and the International Monetary Regime: A Historical Perspective [9780521811330] Claudio Borio , Gianni Toniolo , and Piet Clement (eds.), Past and Future of Central Bank Cooperation [9780521877794, 9780511510779] Richard Burdekin and Pierre Siklos (eds.), De ation: Current and Historical Perspectives [9780521837996, 9780511607004] Forrest Capie , e Bank of England: 1950s to 1979 [9780521192828] Trevor J. O. Dick and John E. Floyd , Canada and the Gold Standard [9780521404082, 9780521617062] Barry Eichengreen , Elusive Stability [9780521365383, 9780521448475, 9780511664397] Barry Eichengreen (ed.), Europe’s Postwar Recovery [9780521482790, 9780521030786] Caroline Fohlin , Finance Capitalism and Germany’s Rise to Industrial Power [9780521810203, 9780511510908] (Continued a er index) Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 h e Great Recession Market Failure or Policy Failure? ROBERT L. HETZEL Senior Economist and Research Advisor Federal Reserve Bank of Richmond Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Mexico City Cambridge University Press 32 Avenue of the Americas, New York , NY 10013-2473, USA www.cambridge.org Information on this title: www.cambridge.org /9781107011885 © Robert L. Hetzel 2012 is publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2012 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication data Hetzel, Robert L. e great recession : market failure or policy failure? / Robert L. Hetzel. p. cm. Includes bibliographical references and index. ISBN 978-1-107-01188-5 (hbk.) 1. Recessions – United States. 2. Monetary policy – United States. 3. Business cycles – United States. 4. United States – Economic policy – 2009– 5. United States – Economic conditions – 2009– I. Title. HB3743.H48 2011 330.973–dc23 2011038742 ISBN 978-1-107-01188-5 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and does not guarantee that any content on such Web sites is, or will remain, accurate or appropriate. Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 vii List of Figures page ix L i s t o f T a b l e s xii P r e f a c e xiii 1 . e 2008–2009 Recession: Market or Policy Maker Failure? 1 2. Recessions: Financial Instability or Monetary Mismanagement? 11 3 . e Great Contraction: 1929–1933 23 4. Monetary Policy and Bank Runs in the Great Depression 46 5. Vigorous Recovery and Relapse: 1933–1939 65 6. Interwar International Monetary Experiments 85 7. Identifying the Shocks that Cause Recessions 110 8. From Stop-Go to the Great Moderation 128 9. Controlling Bank Risk Taking: Market or Regulator Discipline? 149 10. e Housing Crash: Subsidizing Housing and Bank Risk Taking 170 11. Bubble Trouble: Easy Money in 2003 and 2004? 187 12. What Caused the Great Recession of 2008–2009? 204 13. What Caused the Great Leverage Collapse? 239 14. e Distinctions Between Credit, Monetary, and Liquidity Policy 257 15. Fed Market Interventions: e Experiment with Credit Policy 282 Contents Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:48 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 viii Contents 16. Evaluating Policy: What Are the Relevant Counterfactuals? 300 17. e Business Cycle: Market Instability or Monetary Instability? 319 18. Why Is Learning So Hard? 330 19. How Should Society Regulate Capitalism? Rules versus Discretion 342 Postscript 346 B i b l i o g r a p h y 351 I n d e x 377 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:48 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 ix 3.1. Price levels in gold-standard and non-gold-standard countries: 1873–1893 page 35 4.1. e market for bank reserves 48 4.2. Increase in nonborrowed reserves and decrease in discount rate 49 4.3. Money-market interest rates and regional Fed bank discount rates 50 4.4. M2 growth 51 4.5. Federal Reserve credit and currency held by public: 1928–1940 53 4.6. M2 and total, required and excess reserves of member banks 54 4.7. Change in M2 and deposits of suspended banks 55 5.1. U.S. long-term interest rates 83 7.1. Real output per capita 111 7.2. M2 per unit of output and the price level 117 7.3. M1 step function and recessions: 1906–1945 118 7.4. Money-market rates: 1907–1945 119 8.1. M1 step function and recessions: 1946–1981 134 8.2. Nominal output growth, the funds rate, and M1 step function 135 8.3. Real personal consumption expenditures and trend 138 8.4. Deviation of real PCE from trend, short-term real interest rate, and in ation: 1966–1982 139 8.5. Deviation of real PCE from trend, short-term real interest rate, and in ation: 1982–2005 140 8.6. Actual and predicted nominal GDP growth: 1950–1990 141 10.1. Homeownership rate 171 10.2. Real house price growth 172 Figures Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:54 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 x Figures 10.3. Mortgage debt as a percent of total commercial bank credit 180 10.4. Total residential loans for large commercial banks 180 11.1. Real money-market rates 190 11.2. Short-term real commercial paper rates and unemployment rates 192 11.3. Growth in real total private debt 194 11.4. Growth in real consumption and in real household debt 195 11.5. Private debt as a percent of GDP 196 11.6. PCE in ation 198 12.1. Real PCE and trend 206 12.2. Deviations of real PCE from trend 206 12.3. Business inventory/sales ratio 207 12.4. Change in inventory/sales ratio and ISM manufacturing index 207 12.5. Real price of oil 209 12.6. Real personal disposable income and expenditures 209 12.7. Cycle relatives for real disposable personal income 210 12.8. Residential investment’s contribution to GDP growth 210 12.9. Household net worth and home equity wealth as a percent of income 211 12.10. Total nonfarm payroll employment relative to cycle peak 212 12.11. Change in private nonfarm payrolls 212 12.12. Fed funds rate and real PCE shortfall from trend 214 12.13. International growth 215 12.14. Central bank policy rates 215 12.15. Households expectations about future income growth 222 12.16. New issuance of asset-backed securities 225 12.17. Long-term interest rates 226 12.18. Credit default swap spreads 227 12.19. Nonperforming loans as a percent of total loans 228 12.20. Consumer loan interest rates 229 12.21. Consumer credit 229 12.22. Di culty in obtaining credit for small businesses 230 12.23. Relative importance of nancing di culties for small businesses 230 12.24. Single most important problem for small businesses: regulations and taxes 231 12.25. Single most important problem for small businesses: labor quality and sales 232 12.26. M2 growth 237 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:54 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 [...]... of policy discipline the learning that takes place in this ongoing dialectic between present and past hey aid policy makers in evaluating how well their understanding of the past conditions their contingent forecasts of current policy actions When outcomes belie forecasts, policy makers then possess a framework for asking whether the failure lay with the model (the understanding of the world), with policy. .. monitor the use of their resources, physical and inancial, through the protection of property rights One manifestation of this free -market- versus-interventionist debate is the rules-versus-discretion debate Historically, the Federal Reserve has always argued for the conduct of policy based on ongoing discretion For example, Allan Sproul (1963 [1980], 124 and 127), former president of the New York Fed,... follow a rule that provides for a stable nominal anchor and that allows market forces to determine the real interest and, by extension, other real variables (Hetzel 2008b) Historically, the term used here, market- disorder,” has represented several traditions Prior to World War II, the term “credit-cycle” or “real bills” focused attention on speculative behavior in asset markets that led to asset “bubbles,”... unemployment rate to the operation of the price system Markets believed that the funds-rate changes engineered by LAW would result in a level of real interest rates high enough or low enough to keep aggregate real demand equal to potential output Both the market- disorder and the monetary-disorder views ofer an explanation for the historical record of recurrent recessions Each must answer the question of... commercial failures, and the demise of investment banking houses” (Calomiris and Gorton 2000, 120) Although the approach of these authors leaves unspeciied the nature of the macroeconomic shocks that rendered some banks insolvent (monetary or real), their empirical work supports the view that the relationship between instability in economic activity and in the banking system ran from the former to the latter... monetary-disorder view should make contemporary observers cautious about assigning causes to the 2008–2009 recession without the advantage of thorough debate and the perspective of time In the spirit of such debate, this book runs a horse race between the marketdisorder and monetary-disorder views of the most likely causes of recessions, including the 2008–2009 recession he explanation ofered here for both... BST 2012 http://dx.doi.org/10.1017/CBO9780511997563.002 Cambridge Books Online © Cambridge University Press, 2012 2 he 2008–2009 Recession hey also difer over the role played by expectations about the future In the terminology employed here, there have been historically two broad schools of thought: the market- disorder view and the monetary-disorder view Adherents of the market- disorder view believe that... inancial speculation motivated the original Federal Reserve Act Acting on the basis of this speculative-excess or real-bills view, the Fed’s founders established the Fed to eliminate the periodic recessions they associated with excessively risky lending by banks and the subsequent forced liquidation of the resulting bad debt.1 According to the real-bills view, the business cycle originates in speculation that... oscillated between the marketdisorder and monetary-disorder views he former in its credit-cycle manifestation dominated thinking in the Depression and returned with vigor in the 2008–2009 recession According to this view, excessive risk taking of banks caused the Depression and the 2008–2009 recession he change over time in the intellectual consensus about the cause of the Depression from a credit-cycle to... market- disorder view, the monetary-disorder view is that the price system works well to equilibrate the economy, provided that money creation and destruction do not prevent the interest rate from adjusting here is no inevitable movement from boom to bust his view receives empirical content from the hypothesis that to prevent the monetary emissions and absorptions that destabilize the price level, the . future. In the terminology employed here, there have been historically two broad schools of thought: the market- disorder view and the monetary-disorder view . Adherents of the market- disorder. used for policymaking need not be any of the well-known forecasting mod- els. It should represent the policymakers’ beliefs about the way the world works, and it should be explicit. Any policymaker. a horse race between the market- disorder and monetary-disorder views of the most likely causes of reces- sions, including the 2008–2009 recession. e explanation o ered here for both the