Published for www.johnbtaylorsblog.blogspot.com, March 31, 2012
The debate about the causes of the financial crisis and the great recession will continue for many years, and the facts and analysis that Robert Hetzel put forth in his new book The Great Recession: Market Failure or Policy Failure? should now be part of that debate. As I said in my comments for Cambridge University Press, “Hetzel applies his experience as a central banker and his expertise as a monetary economist to make a compelling case for rules rather than discretion, showing that ‘monetary disorder’ rather than a fundamental ‘market disorder’ is the cause of poor macroeconomic performance. At the same time, he acknowledges and discusses disagreements among those who argue for rules rather than discretion.”
One area of disagreement among those who agree that deviations from sensible policy rules were a cause of the deep crisis is how much emphasis to place on the “too low for too long” period around 2003-2005—which, as I wrote in Getting Off Track, helped create an excessive boom, higher inflation, a risk-taking search for yield, and the ultimate bust—compared with the “too tight” period when interest rates got too high in 2007 and 2008 and thereby worsened the decline in GDP growth and the recession.
In my view these two episodes are closely connected in the sense that if rates had not been held too low for too long in 2003-2005 then the boom and the rise in inflation would likely have been avoided, and the Fed would not have found itself in a position of raising rates so much in 2006 and then keeping them relatively high in 2008. For example, if the Fed had raised the federal funds rate above 1 percent earlier (in 2003 and 2004) then the inflation rate would likely not have picked up as much and the Fed would not have felt the need to take the federal funds rate above 4 percent or keep it high. But in reality the Fed overshot and took the funds rate to 5-1/4 percent and held it there until just before the recession began. This is what I was referring to in Thursday’s Wall Street Journal piece when I said the Fed “overshot the needed increase in interest rates, which worsened the bust.”