The Great Recession: Market Failure or Policy Failure?

"Bob had a very distinguished career at the Federal Reserve System. He joined the Federal Reserve System in 1974, at the Federal Reserve Bank of Richmond, and was an advisor to four or five different presidents of the Richmond Fed. In that capacity, he participated in a significant number of Federal Open Market Committee meetings, going back to the 1970s. He retired a couple of years ago. This means that Bob is probably the Federal Reserve official who has been closest to monetary policy for the longest in the US. His own insights are, of course, shaped by being a Federal Reserve insider for many, many years. But he’s also maintained a very strong, independent and academic strand of thinking. Hetzel wrote his PhD with Milton Friedman as his primary advisor. And you can see Milton Friedman’s influence on Hetzel. The Great Recession: Market Failure or Policy Failure is very much written in the great tradition of the Monetary History by Friedman and Schwartz. It’s just a tremendous work. You have to remember this book was written while Bob was still a policymaker/researcher within the Federal Reserve System. It’s a really scathing critique of the conduct of monetary policy in the run-up to 2008 and the aftermath. The Federal Reserve System deserves a lot of praise for allowing that. It would never have happened in Europe. This book actually discusses two things, but at the core of it is a working paper that came out in 2010. The argument in that paper is the same argument that Scott Sumner was making and that I was making at the time, that the cause of what happened in 2008 was not a property market bubble. It was not over-easy monetary policy ahead of that, it wasn’t that interest rates were too low, although they might have been. The main cause was the Fed’s failure to respond aggressively enough, in a rules-based way, to the increase in the demand for money. And that brings us back to Leland Yeager. You have this hoarding of dollars, not by the French central bank, as in the 1920s, but by private investors. When Lehman Brothers collapsed, there was a hoarding of dollars, and the Fed responded to that only gradually and not aggressively enough. That’s really at the core, this monetary disequilibrium as a result of the Fed’s failure to respond. That brings us back to this question about interest rates. If you see interest rates as your measure of monetary policy, you would see that they had cut interest rates to nearly zero. Monetary policy is very easy. Friedman used to say that interest rates are low when monetary policy has been tight. And why is that? Well, if monetary policy has been tight, inflation and inflation expectations are low. As Irving Fisher said, interest rates have two components, a real component and an inflation expectations component—the so-called Fisher equation. And so, when inflation expectations drop because monetary policy is tightened, interest rates are low. There is also what we call a liquidity effect, that if you flood the money market or the bond market with money, you can push up the price of bonds, and thereby push down interest rates. “Monetary history becomes interesting when there are monetary policy mistakes” What Hetzel and Sumner realized in 2008 was that monetary policy was becoming very, very tight. And we can see it from those market indicators. The Fed, for a very long time, thought that monetary policy was becoming too easy because it was expanding the money base and interest rates were low. But Hetzel is looking at many more different measures of the money supply. For instance, if you have all your money in money market funds, what do you do when the world is collapsing? You put money into the bank. In terms of pure monetary statistics this will increase the money supply as it is measured, since bank deposits are part of the money supply, but money market funds are not. That was what was happening in 2008. One of the things that Robert Hetzel is really, really good at is understanding that kind of factor and disentangling these things to say, ‘Well, that is happening, but you should study this and this and this, as well.’ If you look at the so-called TIPS market, the inflation-linked Treasury bonds in the US, the difference between the yield on regular nominal government bonds and inflation-linked government bonds is the inflation expectation for a given period. That difference declined very steeply in the summer and autumn of 2008 and was telling us that monetary policy was tight. If we go back to Money Mischief , Milton Friedman said that the money supply should grow by a fixed rule, or fixed percentage every year, 4% or 5%. That would ensure nominal stability and hence low and stable inflation. But, in doing that, we ignore the fact that demand for money can change, as happened in 2008. That was the thing that Leland Yeager would have told us. But Friedman knew when he wrote Money Mischief that that rule maybe wasn’t the best rule and that Robert Hetzel had actually come up with a better rule. Friedman wrote in 1997: “Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining the inflationary bias that infects government. He proposes that ‘the Treasury be required through legislation to divide its issue of bonds at each maturity into a standard bond and an indexed bond. Interest and principal payments on the indexed bonds would be linked to a price index. The Treasury would be required to issue the two forms of bonds in equal amounts. The market yield on the standard bond, which makes payments in current dollars, is the sum of a real (inflation-adjusted) yield, and the rate of inflation expected by investors. The market yield on indexed bond, which pays interest in dollars of constant purchasing power, in contrast, would simply be a real yield. The difference in yield on the two kinds of bonds would measure the inflation investors expect over the life of the bonds.'” This is what Hetzel had written in an op-ed in the Wall Street Journal in 1991. He had written that op-ed at Milton Friedman’s suggestion. Friedman also suggested to the opinion editor at the Wall Street Journal that they should print it. And Friedman also suggested to the then Treasury Secretary, Larry Summers, that the Treasury should actually issue inflation-linked bonds, which they did in 1997. And, since then, we have had a measure of market inflation expectations. Interestingly enough, that market in 2008 told Robert Hetzel, who had been behind its creation, that monetary policy had become too tight. I think that’s a beautiful story. If we look at the rhetoric today of monetary policymakers at the Federal Reserve, the Fed refers to market inflation expectations to an extent that they never did before. Now he’s retired from the Federal Reserve System, Robert Hetzel, in his commentary on the Fed’s actions over the past 14 months, has been increasingly voicing concerns about monetary policy becoming inflationary—concerns I largely agree on. But both Bob and I have a problem. One of our favourite measures of inflation—namely, market inflation expectations—is telling us not to be too worried. But what we learned from Milton Friedman was that we should be worried when the money supply goes up by 27%. One of the things that permeates all of Robert Hetzel’s writing is that monetary regimes are important, that we cannot analyse monetary policy independently of the monetary regime. The monetary supply going up means one thing if you have a fixed exchange rate policy, but it means another thing if you have no policy at all. It means something else if you have an inflation target. So, what we learn from reading Hetzel and Sumner on top of Friedman, is the importance of these institutions. Another thing that Hetzel discusses in the book is ‘too big to fail’. Just because Hetzel is not saying there was a bubble in 2008 doesn’t mean that he didn’t say there was a problem. He strongly believes in, and spelled out in the book, that financial regulation and different subsidies within the US housing system—ownership guarantees, both implicit and explicit—created a lot of problems in the US banking system in the run-up to 2008. He has a good discussion of ‘too big to fail’ and moral hazard issues in the book. It’s an important discussion of what happens financially in the run-up to 2008, but he doesn’t suggest it’s the main cause. He sets it all out wonderfully in this book."