Into oblivion with an oblivious Fed
The release of transcripts of meetings within the Federal Reserve just prior to the global financial crisis shows its inflation-obsessed economic leaders had no idea what was just around the corner.
Everyone who wants to understand why we’re now mired in a permanent economic slump should read these documents – not because it will explain the slump itself, but because it confirms that those who were supposed to ensure that such calamities didn’t occur were clueless about the approaching crisis. Jim Cramer famously ranted precisely the same message at the time, and copped a lot of flak about it, but he was dead right – and the transcripts prove it.
The best instance of this is the report of the August 7 meeting of the committee, which predated the now-acknowledged start of the crisis by a mere two days. There was of course discussion of the turmoil in financial markets and firms – there could hardly not have been – but that wasn’t the main danger that the FOMC foresaw at this time. Nope, according to most of them, the greatest medium term threat to the economy was … rising inflation!
That was garbage of course, and I’m not merely relying upon hindsight in saying that. As many ordinary citizens could feel, and as a few analysts including me were saying vocally at the time, the real crisis facing the US economy at the time was the bursting of a private debt bubble. But there was literally no discussion of that – not even any awareness of that – at the FOMC.
There was indeed a short-term uptick to inflation, but it was followed by a plunge into deflation as the monthly rate fell from 1 per cent per month in mid-2008 to minus 2 per cent per month in late 2008. The Fed’s and the Treasury’s massive interventions since then certainly played a role in reversing the initial deflation, but as the trend plot shows, that is still the direction in which the US economy is headed.
This trend towards deflation has been evident since 1990, but the FOMC – which is overwhelmingly dominated by conventional "Neoclassical” economists, with Bernanke himself the most prominent example – couldn’t see that. Instead, they interpreted the decline in inflation as one of the positive aspects of "The Great Moderation”, which they in turn attributed to their brilliant management of the economy since 1990, and they wanted to keep on going in driving it lower. To them, the "clear and present danger” facing the economy is always inflation, and even when the annual rate of price increase was as low as 2 per cent, the danger was always that the "Inflation Genie” would pop out of the bottle.
The kindest thing one could say about the FOMC was that it had its eyes fixed on the Inflation Genie that it could see clearly in its rear-vision mirror. It then crashed headlong into Debt-Deflation Genie, which was a far more dangerous creature, that lay straight ahead on the road. The indications that his bottle was open they had completely ignored for the previous six decades.
In reading the FOMC transcripts, I felt rather like Ford Prefect in Douglas Adam’s brilliant Hitchhiker’s Guide to the Galaxy, as he watched the Golgafrinchams attempt to invent the wheel – after the spaceship containing that planet’s hairdressers, public relations executives, opinion pollsters and phone sanitisers had crashed on a prehistoric Earth:
"Ah," said the marketing girl, "well, we’re having a little difficulty there."
"Difficulty?" exclaimed Ford. "Difficulty? What do you mean, difficulty? It’s the single simplest machine in the entire Universe!" The marketing girl soured him with a look. "All right, Mr Wiseguy," she said, "you’re so clever, you tell us what colour it should be."
What colour indeed. As a critic of conventional economics, I don’t expect much from Neoclassically-trained economists, and I therefore generally feel that nothing they would say or do will surprise me. But even I found myself quit literally holding my head in my hands in disbelief at the sheer inanity of the FOMC’s discussion.
In his famous rant, Cramer singled Bill Poole (head of the St Louis Fed) for special mention:
"I have talked to the heads of almost every one of these firms in the last 72 hours and he [Bernanke] has NO IDEA what it's like out there. NONE! And Bill Poole, he has NO IDEA what it's like out there. My people have been in this game for 25 years and they're LOSING THEIR JOBS and these firms are gonna GO OUT OF BUSINESS and it's nuts. They're NUTS! They know NOTHING! This is a different kinda market. And the Fed is ASLEEP. Bill Poole is a shame, he's SHAMEFUL! He oughta GO, and READ the Accredited Home document, at least I READ the darn thing."
How right he was. Here’s Bill Poole’s contribution to the August meeting – with a standard Neoclassical tenet highlighted, that the financial system and the real economy are independent of each other:
MR. POOLE: My overall impression from my business contacts is that things are more of the same rather than anything very much different… My own bet is that the financial market upset is not going to change fundamentally what’s going on in the real economy. First of all, bank capital is not impaired. So unlike in some past cases, when losses on real estate impaired bank capital and thus affected the lending in areas that had nothing to do with real estate, I don’t think that’s the case this time. Second, the fact that some LBO deals fall through isn’t going to change what those companies are producing. The fact that the ownership hasn’t changed doesn’t change the company’s profit-maximising level of production in the short run. Obviously, that could change, but it seems to me that the best information that we now have is that this financial market upset is going to settle out and not have major repercussions on the real economy, putting the housing part aside.
It wouldn’t be so bad if Poole were merely an outlier, while the rest took the financial market turmoil more seriously. But in this sense they were all outliers, because they had all drunk the Neoclassical Kool-Aid in which finance markets are (a) inherently efficient and (b) unrelated to the real economy. This is the real reason why they didn’t take the chaos on the finance market seriously: because according to their Neoclassical models of the economy, whenever turmoil infrequently hit the finance markets, it would be resolved there with little or no impact on the real economy.
This is why the Fed – and the Treasury and most of the economics profession – was "asleep at the wheel” when the financial crisis began. According to their model of the economy ("the car” in the "asleep at the wheel” analogy), the causal link between the physical economy (where goods and services are produced) and the financial markets (where bonds and stocks are priced) is a one-way link running from the real economy to the finance sector. Changes in the real economy can cause stock prices to rise or fall, in this view, but the ups or downs in the stock market won’t affect the real economy – as Poole’s sanguine outlook above illustrates.
This is obvious even in the comments of those members of the FOMC who weren’t prepared, as Poole was, to completely discount the impact of asset markets on the real economy. Janet Yellen, who got some brownie points from progressive economists for at least acknowledging Hyman Minsky back in 2009, is indicative here. The worst she could foresee was that financial market turmoil might reduce economic growth by about half a per cent, and she still saw reasons to keep rates high to contain inflation:
MS. YELLEN: I have lowered my growth forecast for the second half of this year half a percentage point, to just over 2 per cent. This rate is moderately below my estimate of potential growth, which I now put at about 2½ per cent. Going beyond this year, the outlook depends on one’s assumption concerning appropriate monetary policy. I consider it appropriate for policy to aim at holding growth just slightly below potential to produce enough slack in labour and credit markets to help bring about a further gradual reduction in inflation toward a level consistent with price stability. Barring a more serious and prolonged tightening of credit market conditions or a general liquidity squeeze, I would keep the fed funds rate modestly above its equilibrium level to accomplish this goal. However, I now see the fed funds rate as well above the neutral level. So I think it likely that the fed funds rate will need to fall appreciably over the next few years.
Even those who correctly worried that the housing collapse could be dangerous still erred in expecting inflation lay ahead
MR. FISHER: On the housing front, I have been bearish – more bearish than anybody at this table ... In short, I would not be surprised to see disappointing growth in the second quarter, much more disappointing than in the Greenbook’s forecast, nor would I be surprised to see higher core PCE inflation sustaining itself than I am hearing from some of my colleagues and from the staff.
In the end, their concern that the wheel should be beige rather than, say, rainbow-coloured, won the day. Their final communique was read out by Deputy Secretary Ms Danker, prior to being delivered to a waiting press, eager to know what the FOMC intended doing about the financial crisis:
MS. DANKER. I’ll read the directive wording from the Bluebook and the balance of risk assessment from Brian’s handout.
"The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability and promote sustainable growth in output. To further its long-run objectives, the Committee in the immediate future seeks conditions in reserve markets consistent with maintaining the federal funds rate at an average of around 5¼ per cent.
"Although the downside risks to growth have increased somewhat, the committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.”
Chairman Bernanke: Yes
Vice Chairman Geithner: Yes
President Hoenig: Yes
Governor Kohn: Yes
Governor Kroszner: Yes
Governor Mishkin: Yes
President Moskow: Yes
President Poole: Yes
President Rosengren: Yes
Governor Warsh: Yes
And shortly after these pearls of wisdom were delivered, economic growth in the US economy plunged by not a half of one per cent as Yellen guessed it would, but by 7 per cent:
Douglas Adams got only one thing wrong in The Hitchhiker's Guide to the Galaxy: he forgot to include economists in the "entire useless third of their population” that the Golgafrinchams got rid of by dumping on Earth.
Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.