Fed study says Bush and the banks didn’t cause the Great Recession. The Fed did
By James Pethokoukis @ AEI (August 27, 2012)
It’s probably President Obama’s most politically effective line of attack against Mitt Romney.
The president argues that it was the unchecked, reckless, casino capitalism of the George W. Bush years — bank deregulation, tax cuts for the rich — that lead to the nation’s worst economic downturn since the Great Depression. And if Mitt Romney is elected in November, the Republican will bring those policies right back, risking another financial collapse.
Here’s what Obama said during that same speech where he told America’s entrepreneurs that “you didn’t build that”: ‘But I just want to point out that we tried their theory for almost 10 years … and it culminated in a crisis because there weren’t enough regulations on Wall Street and they could make reckless bets with other people’s money that resulted in this financial crisis, and you had to foot the bill. So that’s where their theory turned out.’
But a book by Robert Hetzel, a senior economist at Federal Reserve Bank of Richmond, says it wasn’t Bushonomics or greedy bankers or broken markets that caused the Great Recession. In The Great Recession: Market Failure or Policy Failure, Hetzel pins the blame squarely on the Federal Reserve and Team Bernanke.
Oh, the downturn first started with “correction of an excess in the housing stock and a sharp increase in energy prices” — the housing bust and the oil shock. Indeed, those two things were enough, in Hetzel’s view, to cause a “moderate recession” beginning in December 2007.
But only a moderate one. It was the Fed’s monetary policy miscues after the downturn began that turned a run-of-the-mill downturn into a once-in-a century disaster. Hetzel: ‘A moderate recession became a major recession in summer 2008 when the [Federal Open Market Committee] ceased lowering the federal funds rate while the economy deteriorated. The central empirical fact of the 2008-2009 recession is that the severe declines in output that in appeared in the [second quarter of 2008 and the first quarter of 2009] … had already been locked in by summer 2008.’
Not only did the Fed leave rates alone between April 2008 and October 2008 as the economy deteriorated, but the FOMC “effectively tightened monetary policy in June by pushing up the expected path of the federal funds rate through the hawkish statements of its members. In May 2008, federal funds futures had been predicting the rate to remain at 2% through November. By mid-June, that forecast had risen to 2.5%.
And it wasn’t just the U.S. central bank. Hetzel thinks all the major central banks — the European Central Bank, the Bank of England, the Bank of Japan, sat on their hands as the global economy weakened. “The fact that the severe contraction in output began in all these countries in 2008:Q2 is more readily explained by a common restrictive monetary policy than by contagion from the then still-mild U.S. recession, Hetzel writes in a Fed paper that inspired the book. “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. Irony abounds.”
Here’s another reason Hetzel lets Wall Street off the hook. If a banking collapse was the true villain rather than the Fed, bank lending should a) have been a leading indicator and b) should have declined more significantly than in past recessions. But this chart of bank lending, adjusted for inflation with recessionary periods shaded, shows “bank lending behaved similarly in this recession to other post-war recessions.”
The irony here, of course, is that Federal Reserve Chairman Ben Bernanke is a much-noted student of the Great Depression and of the work of the late Milton Friedman whose landmark book, A Monetary History of the United States, pinned the blame for the Great Depression on a too tight Fed. As Bernanke told Friedman and his co-author, Anna Schwartz, on the economist’s 90th birthday a decade ago, ”You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
But if Hetzel is right, the Fed blew it again.
The analysis will be much debated and probably won’t have much impact on the election or public perception of the Bush years anytime soon. And bankers are unlikely to see their approval ratings rise. But Hetzel’s work suggests policymakers should take notice and perhaps think twice about placing more faith and power in regulators or abandoning pro-market polices because they somehow caused the financial crisis and Great Recession.