Science Is Prediction: Back-Testing the Market Monetarist-Endorsed Ted Cruz Explanation for the 2008 Crash
(Please don’t lecture me on the post title: I am making a wisecrack related to Dan’s very useful advice on a previous post.)
Recently Ted Cruz was grilling Janet Yellen. So far, so good. But then he said:
Senator Cruz: In the summer of 2008, responding to rising consumer prices, the Federal Reserve told markets that it was shifting to a tighter monetary policy. This in turn set off a scramble for cash, which caused the dollar to soar, asset prices to collapse, and CPI to fall below zero, which set the stage for the crisis. In his recent memoir, former Chairman Ben Bernanke says that the decision not to ease monetary policy at the September 2008 FOMC meeting was “In retrospect certainly a mistake.” Do you agree with Chairman Bernanke that the Fed should have eased in September of 2008 or earlier?
Scott Sumner and David Beckworth were both pleased with this line of questioning, and Scott also linked with approval to a Washington Examiner article saying Cruz’s questioning reflected Market Monetarist influence.
Now obviously, Scott and David are trained economists, and experts in Market Monetarism, so they would’ve been more nuanced if they had had the opportunity to grill Yellen. But if you read their commentary, I don’t see anything except a high-five for Cruz in this exchange. (They of course disavow his earlier support for the gold standard.)
All right then, with that background, to the point of my current post: I am wondering what kind of statement you guys think the Fed had to issue back in “the summer of 2008” that ultimately caused the financial crisis. Go look at Cruz’s statement above; he is definitely saying that the chain of events was that the Fed told markets something, and then this caused dominoes to start falling that ultimately led to the crisis in the fall.
In the comments (e.g. here) at various places where Cruz’s questioning was being discussed, I asked people for a link to the actual Fed statement in the summer of 2008 that Cruz had in mind. The only answer I saw (maybe someone answered after I stopped checking) was Scott himself, who said:
SCOTT SUMNER, EXPLAINING WHAT THE FED STATEMENT IN THE SUMMER OF 2008 WAS: “Bob, I’d guess he’s responding to Fed statements that they were increasingly worried about inflation, and likely to tighten in the future. (Which of course they did.)”
OK so now, without looking, I would like you guys–especially if you are fans of Sumner–to type out your guess as to what the Fed’s statement(s) in the summer of 2008 probably sounded like, to explain how the Ted Cruz / Market Monetarist theory is plausible, in that it was not underlying “real forces” but in fact the Fed pushing expectations through its statements/actions in the summer of 2008 that caused the global financial crisis a few months later.
So please, type out your guesses in the comments of this post. In a few days I’ll paste what the Fed actually said. But NO CHEATING: You are on your own intellectual honor, I want you to type out the type of Fed statement in the summer of 2008 that you think plausibly explains the global financial crisis.
One last thing: Even after you type out your own guess, and then if curiosity is killing you and you go look it up, please don’t spoil it for others by posting it here. Let’s keep this comment section reserved just for people’s guesses. And again, I want to stress that I’m hoping for fans of Market Monetarism to chime in here. I want you to tell me, off the top of your head (that’s important for this exercise), what type of thing the Fed said in the summer of 2008 that you think is a much better explanation for the subsequent financial crisis than the housing bubble or some other “real factor.”
“Yikes, soaring oil prices+rising unemployment!”
And you know those Fed statements hedge like there might not be a tomorrow.
Also, there’s no doubt Ted Cruz has just begun to listen to Sumner.
For those who are just joining us, I strongly encourage you to say something more elaborate than what E. Harding has done. There is nothing in his statement about tighter monetary policy.
Come on, Bob, that was way more revealing than the comment of mine you deleted.
Bob, at the scheduled meeting the day after the Lehman failure, the head trader for the Fed told the committee that forward markets looked like they expected a rate cut of 25bp, but that this really reflected a significant part of the market that expected rates to fall 50 or 100bp and for the economy to crash. Then committee members shared reports of banks in their districts who had to turn away clients with good credit for lack of cash. Then they proceeded to keep the Fed Funds Rate at 2% because of inflation fears, even though tips breakevens were crashing. Shortly after that they began paying interest on reserves. In the context of the time these were outrageously hawkish positions. Most of the decline in the S&P 500 happened after that meeting, most unemployment happened after that meeting, and most of the housing defaults happened after that meeting.
At this point, is the disastrously tight posture of the Fed in the summer of 2008 even in doubt?
Thank you for participating, Kevin, let’s give 48 hours for others to offer their own thoughts, and then I will respond.
Sorry if I broke protocol. I promise my comment was from memory, though, so technically I followed the rules.
Kevin you’re fine, that’s exactly what I wanted. (Though to not be coy, my response to you is going to be that September is not in summer.)
Yeah that is a significant item… for some reason I thought that started a bit later, but probably I only caught onto what was happening well after it started.
In the interest of the game I haven’t run to look that up either.
Well, its down in Market Monetarist folklore that they expressed concern about rising unemployment , financial sector instability, but greater concern about inflation. And the market took that to be a signal for tightening.
I’m assuming that as you are doing this post – that the folklore is wrong.
Transformer yes, you are describing the Market Monetarist position. But I’m asking what you think the actual language was to map to Cruz saying “the Federal Reserve told markets that it was shifting to a tighter monetary policy” and/or Scott saying “Fed statements that they were increasingly worried about inflation, and likely to tighten in the future.”
I want people to type out what that language looks like, before we go check to see what the Fed actually said.
OK, I honestly have not looked this up, and I’m going entirely on my memory of the time, and what Cruz said.
There were already signs of crisis earlier than summer 2008, in terms of falling home prices and some pressure from mortgage resets (but the big nasty stuff hadn’t happened yet). Bernanke was known for his famous low interest rates and his “Bernanke put” and I think they might have already been calling him “helicopter” by that stage… maybe that came later.
I would say Bernanke would have given a broadly reassuring statement that the economic intrinsics were very good (safe call I think, he said that all the time) any risk of contagion was negligible, the mortgage marked was in great shape, and probably something to give handwaving attention to moral hazard while also a bit of a wink that the “Bernanke put” would still be in business if anyone needed it, because moral hazard is for little people.
No mention of QE yet though, I’m sure that came at least 6 months later, maybe 12 months.
What he said about interest rates? Dunno, it’s always something vague but I would guess he talked about how he was going to raise them, you know whenever, not soon.
Helicopter Ben was known so long before he became Fed chair.
Note: this image:
http://www.businessweek.com/the_thread/hotproperty/bernanke-helicopter.jpg
is from 2007.
Why single out Ben. This pic gives equal time to all:
http://gregmankiw.blogspot.com/2013/10/congratulations-janet.html
Bubbles don’t exist yet the Federal Reserve should have known that the skyrocketing oil prices in 2008 were, um, a bubble that would pop and break the trend of 4%+ inflation. This is the insanity of the monetarism preached by Sumner and his disciples. Futures markets are supposedly prescient except when they are not. And people like Sumner will know which is the case.
Ok, newly minted MM fanboy here and I guess that the Fed said in WORDS: We stand ready to do WHATEVER is needed to keep the banksters happy and credit markets working. But, what the said in DEEDS is: Hey, do you guys think we are lowering rates any more than we have? Come on. All the gold bugs like Rand Paul and Ted Cruz will have us tarred and feathered! I certify this is my guess with no googling.
Seriously Dr. Murphy. Please make a truce with Scott Sumner. How can you not fall in love with NGDPLT? It’s brilliant! Target the market expectation! It’s an inspired way out of the Milton Friedman cognitive dissonance of “markets in everything except central planning for monetary policy is OK.” You don’t really want Francisco D’Anconia for Fed chair like Sen. Cruz does, do you?
Just want to go on record that Dagny Taggart would be my first choice for Transportation Secretary.
Capt J Parker so to be clear, you think “the Fed told markets it was shifting to a tighter monetary policy” means “we are not cutting rates any more at this point” ?
What would the Fed have to say to markets, to signal that it was maintaining the existing level of monetary tightness?
Trust us: inflation will not fall below 1%.
or
0% NGDP growth? Nonsense. Not under our watch.
“to be clear, you think “the Fed told markets it was shifting to a tighter monetary policy” means “we are not cutting rates any more at this point”
Almost, more like: Fed told markets it was shifting to a tighter monetary policy means we are not cutting rates any more at this point even though unemployment is still increasing and credit institutions are still in tough shape.
“What would the Fed have to say to markets, to signal that it was maintaining the existing level of monetary tightness?”
Yes, I admit its hard to formulate a succinct answer to that but, it’s a bit of a trick question so I’ll answer like this: What the Fed actually did was shift From a “whatever it takes” stance to a “we’re good for now” stance. To signal it was still on a “whatever it takes” stance it would have announced we will continue to either cut rates or buy assets until credit markets or unemployment stabilizes.
I’m buying into the idea that the Fed had reason to believe 2% was still above the Wicksellian rate in the summer of 2008 yet it stood pat at 2%. That’s tightening.
“It’s an inspired way out of the Milton Friedman cognitive dissonance of “markets in everything except central planning for monetary policy is OK.”
Except, you know, it still depends on that very cognitive dissonance.
You can’t square the circle here by merely changing the centrally planned monetary policy rule.
Apparently the cognitive dissonance persists in MM circles.
Bob Murphy wrote: “he is definitely saying that the chain of events was that the Fed told markets something”
Bob, do you recall that for Market Monetarists a failure to act is to act? Then maybe a failure to tell something is to tell something 🙂
Hahaha
Agreed.
Wow, this is some inside baseball. But I love the style.
Bob, if I were to guess, I think the Fed signaled what Cruz claimed it signaled not by the words they actually said, but by the words they did not say. That is to say, it is the fact that the Fed did not “We will continue to cut rates without regard to inflation concerns” that led the market to conclude that the Fed wasn’t committed to loose monetary policy for much longer.
While we have observed inflation due to supply side factors in the oil market and anticipate that these forces may continue to impact the CEP over the next six months, the Federal Reserve stands ready to expand the monetary base whatever amount is needed to reverse the modest slowdown in growth of spending on output observed the past six months and then maintain spending on output on the growth path of the Great Moderation. The Federal Reserve will not allow inflation due to supply side factors to influence its efforts to keep nominal GDP on the target growth path.
The Federal Reserve cannot meet its strong commitment to stable growth in spending on output without allowing market forces to influence interest rates. Disruptions in credit markets due to mismanaged of some large financial institutions may result in decreases in the yields on short and safe financial assets. The Federal Reserve will not use monetary policy to keep these yields from falling. Any such effort could only be successful only over the shortest time horizons and would be as disastrous as efforts to prevent increases in interest rates in inflationary and booming economies in the past. We anticipate reorganization of mismanaged financial firms and shift in market share to better managed firms. The Federal Reserve cannot and will not promise that investors in mismanaged financial firms are insulated from loss.
We have communicated in the strongest terms to our partners in the European Union that naive inflation targeting is very dangerous and can easily result in central banks turning a mild growth recession into a severe downturn. If the Eurpean Central Bank continues on its current course, we anticipate a weaker dollar. The Federal Reserve will not move to protect the dollar or prevent inflation in the prices of imported goods, but will maintain its commitment to slow steady growth in nominal demand for domestic U.S. output.
Reallocation of labor and other resources from housing to other sorts of investment and consumer goods production will likely continue to result in somewhat hightened unemployment over the next several years. As the economy continues to readjust, unemployment should fall again over the next few years. While this adjustment process may be associated with modestly higher prices in expanding sectors, neither will the Fed take action to offset such sectoral inflation nor will the Fed seek to generate more rapid aggregate growth in spending in a futile effort to offset these modest increases in structural unemployment due to needed reallocations of resources.
Bill what is this in response to? I’m assuming this isn’t what you think the Fed said in the summer of 2008 to panic markets, so I’m not sure what this is?
Bill Woolsey’s post is definitely written in Central Bankish. I’m willing to bet that its late 2007 early 2008 given the reference to “modest” slowdown in output spending. So, it looks to me that early on the Fed said it “stands ready to expand the monetary base whatever amount is needed to reverse the modest slowdown” and wagged its finger at the ECB and warned not to do dangerous naive inflation targeting that turns modest slowdowns into recessions and then in mid 2008 the Fed told the markets “Gee, inflation targeting isn’t really all that bad after all, Lets give it a go, shall we?”
It’s what Market Monetarists would have wanted the Fed to have said.
That’s what I thought too E. Harding, but it’s kinda like I say, “Hey, who wants to play me in chess?” and then Bill Woolsey starts rolling dice on the table.
So where’s the answer then?
Time sup!
http://www.federalreserve.gov/newsevents/press/monetary/20080916a.htm
http://www.federalreserve.gov/newsevents/press/monetary/20080625a.htm
http://www.federalreserve.gov/newsevents/press/monetary/20080805a.htm
Checkmate for Bob.
Again.