Krugman, Delong and myself have taken to dragging up old posts from when this crisis began. In part, this is because as professors we have less free time to write new posts as the semester begins. In part, its because its fun to say “I told you so.” I would be lying if I denied that.

However, importantly its also because there were and still are multiple theories floating around about what happened. Those theories made different predictions about how the financial crisis would play out and by matching our predictions to reality we build evidence for or against individual theories.

This is how many, if not most, big scientific theories work. We are not performing repeated experiments to see if all life on earth evolved from single celled organisms. As far as I know no one has done a randomized controlled trial of Big Bangs to see if one produces a universe just like ours.

No, instead different theories yield different predictions for the evolution of observational data. By examining that data we build a case for a theory.

All of that is prelude to the following: My co-blogger Niklas quotes Brian Westbury in February of 2008

So I would say that today we have very low interest rates, we have low tax rates, and we are not moving in a protectionist direction. As a result, those conditions that have led to recessions in the past don’t exist. One last point: I know of no point in history where we have ever scared ourselves into a recession. It just has never happened before and I don’t think it will happen this time, either.

This was clearly a mistaken theory of how recessions come about. Others have spent time and energy dismantling this market-clearing fully supply-side theory of macroeconomics. I don’t need to do that here.

Niklas, however, sticks up for Westbury to some extent by saying

By late 2008, in hindsight, Wesbury looks like a fool…but how would he have possibly known that the Fed would let NGDP fall at the fastest rate since 1938 later in the year? As a counterfactual, had the Fed kept up expectations that it would hit its 5% NGDP growth target, Wesbury’s statement wouldn’t look so bad today.

Not to put too fine a point on it but Niklas – using the monetary based Scott Sumner theory of recessions – is saying: Hoocoodanode?!

Well, quite frankly, I could of knowed. I did know. And I tried to tell my fellow economists. At the exact same time Westbury was arguing his case, I said

Inflation is here, yes. Commodity prices in general and agricultural prices are skyrocketing. This is something that we talked about here last year. However, the Japanese Scenario is becoming more salient everyday.

As I say regularly to my colleagues, “This is not just sub-prime, this is not just housing. This will get much worse before it gets better”

[ . . . ]

[The Japanese] scenario must be avoided. The Fed should acknowledge that inflation is a problem but should begin to brace the nation for a policy designed to beat back a Japanese style depression without regard for the immediate implications for inflation.

In other words, my fear was that we were headed for a Japanese style depression and that the Fed needed to immediately abandon traditional monetary policy and rapidly loosen the money supply.

The fact that I was able to make these predictions, this early on, points out an important difference, perhaps the only significant difference, between how I see the world and how Scott Sumner sees the world.

Scott and I both agree that the real price of money increased rapidly during 2008 and this triggered the recession.

What I saw in late 2007 and accelerating into early 2008 was an unprecedented surge in Money Demand. That surge was unlike anything I had ever seen, heard of, or even imagined to that date. It was frightening beyond all measure and I thought that the Fed needed to move immediately into an extremely accommodative posture in order to avoid a liquidity trap and a crushing recession.

The Fed did not do that, we did in fact fall into a liquidity trap and the result was a crushing recession.

The story Scott tells is somewhat different. He speaks as if somehow the Fed either purposely or through causal indifference decreased the Money Supply – or to be more general, tightened monetary policy – in 2008. If this is how you see the world, then the ultimate cause of the crisis was the Fed and no one could have known in early 2008 that the Fed was going to behave in such a nonsensical way.

On the other hand, my contention was that the collapse of major financial firms and wide spread uncertainty about the price of important financial assets was creating an enormous upsurge in Money Demand. It was then obvious that either the Fed was going to have to act in a highly unusual way or the result would be an enormous recession and the possibility of a liquidity trap.

I think history bears out my view.

Settling this issue is important for how we think about handling future crises and how we work our way out of this one.

My view is that we stared into the abyss and to a large extent froze. The monetary authorities did not respond with sufficient speed and power to what was a clear and present danger to the financial security of the entire world.

In my view TARP was crucial but it came far too late and probably should not have been entrusted to Congress to begin with. The Federal Reserve should have moved immediately and unilaterally to prevent the failure of major institutions and runs on any part of the shadow banking sector. There are worse things in the world than moral hazard, we are experiencing them right now and it seems likely we will continue to experience them for near future.

In addition, the Fed should have rapidly and intensely expanded the money supply early in 2008, driving down rates across the yield curve.

Scott’s view is that if we just had the good sense not to tighten monetary policy none of this would have happened. Further, Scott thinks that solving this crisis centers around doing what he always thought should be done: adopting an NGDP target.

I am not fundamentally opposed to an NGDP target. However, I am a small “c” conservative by nature and am not fond of throwing in additional policy mechanisms, which no one can be sure will function how the designers intend for them to function.

Instead, I see the problem as a failure to recognize the enormous surge in money demand that was coming and thereby failing to accommodate it. Further, now that we have hit the zero lower bound I see a higher inflation target as the only simple and sure way out.

I think people understand what inflation is. Bankers and businesses get the basic idea of how inflation works and if the Fed says: look we are committing to a new inflation regime, then everyone will know exactly what that means.

This will allow the Fed to provide the monetary accommodation that should have been provided at the beginning of the crisis. It will also give the Fed more room to apply monetary accommodation in the face of future crises.

All of this I see as more fundamental than stimulus, financial reform or any of the like. I argue that we should have, and indeed many of us did, see the crisis coming in real time. The appropriate response was clear. The consequences of not taking the appropriate response were equally clear.

The Fed chose not to take the appropriate response and we are living with those consequences: a economy eerily reminiscent of Japan in the 90s, falling inflation, falling long term interest rates, rising unemployment, rising national debt, weak asset prices and the prospect of a generation of pain and poor economic growth.

And yes, we could of knowed.

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