Q: What do you think economic historians will look back on in the decades ahead as the lasting lessons learned from the various policy responses to the recent financial crisis? Which will historians approve of and disapprove of?
I think economic historians will examine the responses by episode. They will first look at the big liquidity expansion that occurred in the fall of 2007, when the funds rate was dropped from 5.5 percent to the vicinity of 2 percent. Then they’ll look at what happened after the failure of Lehman Brothers in September 2008. Those were two big monetary expansions. They’ll also look at the pause in monetary expansion in the first half of 2008, because of the fear of a run up in inflation—commodity prices were rising. Third, they will examine the credit operations that occurred in 2008 and the expanded use of the discount window under Section 13.3 [which gave the Fed emergency lending powers]. The fourth would be the bailouts of the government-sponsored enterprises (Fannie Mae and Freddie Mac) and AIG in the summer of 2008. And then the last would be quantitative easing (QE).
I think that they’ll likely approve of the liquidity expansion that occurred in the fall of 2007 and probably also the one that occurred after Lehman. And I think that QE1 was also a policy that will get very high marks in the future. But there are questions about the others. I think there are questions about the reason why they paused expanding money in early 2008, that in a sense, they may have made sure there was going to be a recession. Here I’m relying on Bob Hetzel’s book [The Great Recession: Market Failure or Policy Failure?]. I think he’s right when he says that the Fed made a mistake, and I think history will back that up.
Also, I think there are issues that will come up with respect to the credit operations and expanded use of the discount window under Section 13.3. I think the Federal Reserve’s independence will be an issue, that it lost a lot of independence to the fiscal authorities. In fact, I would describe it as moving toward fiscal dominance—that was one thing that the Fed had a number of issues with in earlier history, and I think it was something that was a really big setback for the Fed in the recent crisis.
What comes out of the credit policies and of QE2 and QE3 is the issue of following discretionary monetary policy and focusing only on the short term. Allan Meltzer and others, such as Marvin Goodfriend, have criticized the Fed for following very discretionary policy—looking exactly at what’s going on right now, not being too concerned about the medium term and sort of forgetting the long term, and in a sense forgetting the kind of rule-like behavior that it was starting to follow in the Great Moderation. So I think this will be an episode that will be discussed for a very long time.
Right now, there’s been criticism by the Shadow Open Market Committee (an independent group that critiques Fed policy) and the people I mentioned before. The Fed of course is pushing back on everything. But I suspect that when enough time has elapsed and it’s not quite a hot issue, we’ll find that the Fed gets high marks for some of the things it did—and in fact, it’ll get extremely high marks in that we didn’t have a repeat of 1931, we didn’t have a Great Depression—but lower marks for dropping the ball on a number of issues, like the fact that after 2007 it was primarily a solvency story and not a liquidity story. And the issue of expanding the discount window is that you ended up providing funds to just about everybody. I think this is a major expansion of the mandate.
Q: To follow up on your view of the credit operations—when you say the Fed lost independence to the fiscal authorities, do you mean that there was political pressure that the Fed bowed to? Or are you saying that simply by engaging in credit allocation, the Fed essentially started doing what fiscal authorities do, and in that way it lost its independence? Can you clarify this point?
The Fed lost independence both in the sense of its cooperation with the Treasury in the bailouts in the heat of the crisis in 2008. It also engaged in credit allocation policies which were fiscal and not monetary actions.
Q: Economic history contains lessons for both governments and central bankers; what concerns you the most about each of these circumstances?
I think the Fed should be worried about its large balance sheet. I’m not sure it needed to do what it did. But given that it did it, and that the monetary base is more than $3 trillion, there’s this issue of credit risk, of the possibility of actually taking losses on some of the paper it’s been buying. I know it’s not like the Fed is going to go bankrupt, but this is the issue: If there is credit risk and there are losses, that means there’s going to be a connection to the Treasury, because the Fed’s profits go to the Treasury, and that contributes to reducing the fiscal deficit. So to the extent that the Fed takes losses, it doesn’t contribute as much. I know this is probably small change, but it is a concern. For other countries, of course, whose central banks aren’t as solvent, the credit risk issue could be much larger than it is for the Fed. But I think it’s there.
Another issue is how they unwind it. The Fed says, “No problem—when we need to, we can pay interest on reserves, tighten it in a very orderly way, and prevent a serious recession.” I don’t know, maybe. You never did it before. You’re talking about policy tools that you just invented, or that other countries invented that you took on in 2007. I don’t know if it’s going to work. It’s not clear cut, it’s uncharted waters. I’m not as confident.
Another issue is quantitative easing. I think the Fed did the right thing in QE1. I think that really helped us get out of the bottom of that recession. But I don’t think we need it any longer. I think we didn’t need QE2 and it didn’t do very much. And QE3 is the same story. I’m not sure we should be doing this. And the reason I don’t think it’s so great is I worry about the risks of future inflation.
It could come from the rest of the world and the carry trade, and the effects of that on global money and commodity prices feeding back to the U.S.; that’s one possible problem. There’s also the international sphere and the fact that the emerging countries are affected by our low interest rate policy leading to huge capital flows that could possibly trigger asset price booms and later busts when we tighten. And we had really low interest rates and these huge capital inflows so they have these huge asset booms. This is a problem that is not given enough attention to.
Another issue is the Fed’s emphasis on unemployment and targeting unemployment and real growth. I know it’s the mandate, but I’m saying I think it’s a misplaced mandate. The Fed should be focusing on price stability, full stop.
Also I don’t really think the Fed should be as heavily involved as it is in financial stability. When it was arguing for Dodd-Frank, the Fed wanted a lot more power, and it got it. I think that is a real time bomb because it means you’ve got a number of goals to deal with and you are distracting from your main purpose.
There is a parallel here with the debate in the FOMC in the 1990s over exchange market intervention, which is discussed in the book I wrote with Owen Humpage and Anna Schwartz (see select publications at bottom). The reason exchange market intervention was put on a very far back burner in the early 1990s was that it was thought that the Fed wanted the public to believe in the credibility of its commitment to low inflation. Following such a strategy could be viewed as conflicting with sterilized exchange market intervention at the behest of the Treasury. The FOMC at the time, to its credit, recognized this problem and decided it wasn’t worth doing. So I think that focusing on multiple goals including financial stability and real growth are distractions from the Fed’s principal mandate.
I also have problems with the Fed making these long-term, forward commitments on interest rates. I think that that has a lot of pitfalls. I think the Fed should be much more contingent in their statements and much more flexible. I think they’re moving in that direction, but I was very concerned when they announced that policy.
And lastly, and this is a point that other people in the Shadow Open Market Committee make, is that the Fed needs to follow rules. It needs to follow rule-like behavior, be transparent about what the rules are, make the rules predictable, and in a sense really follow through on doing things that have a long-term horizon. It should really get away from discretion. I think the Fed has moved far in the direction of discretion and it’s back to a type of policymaking that it had before the Great Moderation.
Q: Can you explain a little more what you mean by rules? By way of background, the Fed has recently adopted an explicit numerical objective for inflation, and it also laid out the principles it would follow in unwinding its large balance sheet. Are those not rules, or do you mean something else?
These actions by the Fed are commendable. It would be even better if they followed more closely the strategies of other inflation targeting countries like Canada, Australia, New Zealand, and the Nordic countries. The flexible inflation targeting approach followed by Norway and Sweden might be a direction that should be seriously considered.
Q: I’m struck that you and others who are speaking at this conference are quite critical of some aspects of Fed policy.
You need outside observers to do that—that’s how you learn. You learn from criticism and you try to take on board the criticism, and if the criticism is not valid try to show it. One of the lessons from the experience of the Great Depression and the Great Inflation is that monetary policy makers were cloistered in a cocoon of their own (later to be proven incorrect) theoretical frameworks. So if you only invite people that are in the same boat, all you do is insulate yourself from really learning from possible mistakes that you’re making. I think it is a good thing that you have some critics here.
Q: You have written extensively about exchange rates regimes—fixed, floating, and various creatures in between those poles. Yet, you don't hear much these days about exchange rates and exchange rate regimes in discussions about U.S. economic conditions or policy. Do people underappreciate the importance of this topic in economic discourse?
The big debate about the monetary regime—fixed versus floating—was in the context of the Bretton-Woods system that we were under in the 1950s and 60s and into the 70s, and its breakdown. It took a long time for us to move from the managed peg system that we were on to the fully operating floating exchange rate system, without much central-bank intervention.
This was a period of flux, when people doubted the benefits of floating. Some people thought we should be going back to some kind of fixed exchange rate regime. Now we’ve shifted to floating, along with other advanced and some emerging countries, and we have been very successful at it. For a floating exchange rate to work, you have to have stable monetary policy, because the instability in exchange rates had a lot to do with the instability in money and prices. Once central banks during the Great Moderation figured out how to follow stable monetary policy and focus on low inflation, then exchange rates became less important. In fact, the exchange rate was very successful in mitigating many of the big global shocks that we experienced since the 1970s. It’s become so successful that people in advanced countries don’t doubt it.
Now, of course, this is not quite the case with emerging countries; because they’re less financially developed, they’re much more easily affected by capital flows and by the carry trade. It’s hard for them to absorb capital inflows and rapid outflows. So the exchange rate regime becomes an issue that is always front and center for those smaller emerging market countries.
It’s also important in the context of the European Monetary Union. They made a decision to not give up floating, and instead go to a complete currency union. And now we find that maybe they made a mistake because they gave up the option of using monetary policy to deal with serious negative shocks to the economy, and they don’t have a fiscal union that could be a substitute stabilizing mechanism. So they’re really up the creek.
It’s not that exchange rate regimes are not important any more—they’re really important for emerging countries. They’re really important for open economies like Canada, Australia, and New Zealand; the exchange rate is of crucial importance to the Bank of Canada in its policy deliberations. But for the U.S., as a big open economy where what we do has effects on the rest of the world that we don’t have to worry about, the exchange rate floats. Treasury Secretaries always have to say they believe in a strong dollar. But they never do anything about it. They say it, because they can’t say “we like a weak dollar” for fear of spooking the markets, even though a weak dollar is a very good thing when you’re in a recession. So the rhetoric is there, and the rhetoric about China is there, as it was about Japan 20 years ago. But in terms of action on exchange rates, nothing has happened in a long time. And nothing probably will.