The Summer of 2008: So What Happened?

Like many people out there, I am eagerly awaiting the release of the full transcripts of the Fed’s monetary policy meetings for 2008. When they come out (and it should be very soon), you will be able to find them here.

I expect that the media will have a field day with these. No doubt a number of Fed officials will have said things that, with the benefit of hindsight, they wish they had not said, or said somewhat differently.

Jim Bullard, president of the St. Louis Fed, recently gave a speech on the subject titled: The Notorious Summer of 2008. The slides associated with that speech are available here.

Bullard makes some very good observations.

First, many people think of the financial crisis as beginning in the fall of 2008, with the collapse of Lehman and AIG. In fact, the crisis had been underway for more than a year at that point (August 2007). The fact that the crisis had gone on for over a year without major turmoil suggested to many that the financial system was in fact relatively stable–it seemed to be absorbing various shocks reasonably well. Throughout this period of time, the Fed reacted with conventional monetary policy tools–lowering the Fed Funds target rate from over 5% to 2% over the course of a year.

So what happened? Essentially, an oil price shock. By June 2008, oil prices had more than doubled over the previous year. The real-time data available to decision-makers turned out to greatly underestimate the negative impact of this shock (and other factors as well). The rapidly slowing economy served to greatly exacerbate financial market conditions.

The Bear Sterns event occurred in March 2008. The firm was purchased by J.P. Morgan (JPM) with help (bailout, depending on one’s perspective) from the Fed. Bullard identifies two problems with that deal. One, it suggested that all financial firms larger than Bear could expect some form of insurance from the Fed. Two, while the deal was successful in calming down markets, it possibly had the effect of lulling them into a false sense of security.

Of course, we then had the infamous Lehman event in the fall of 2008. But as Bullard points out, everyone knew that Lehman’s was in trouble for at least a year–surely investors were prepared for this. And in any case, investors would have properly insured themselves, no?

Well, no. The big insurer, of course, turned out to AIG. Evidently, very few people had any idea about the potential problems with AIG at the time (which, by the way, was outside the scope of Fed supervision). And so, it was the Lehman-AIG event that brought all financial firms under heightened suspicion–and it was this event that drove the financial crisis from September 2008 and onwards.

We all know how the Fed reacted at the time, and since then. The interesting question here is what the Fed might have done differently in the time leading up to the start of the crisis in 2007 and beyond? It is important to answer this question, I think, in the context of policy making that is constrained to operate with the use real-time data (that is frequently subject to significant revisions as time unfolds).

In any case, it will be interesting to eavesdrop on the discussions that occurred in 2008.

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