The Final Piece of the Puzzle

Fasten your seatbelts; it could be a very interesting next few days. I will get to all the comments from yesterday, but first there is breaking news that I found quite exciting (when you hear it you’ll probably be thinking: “Exciting? Get a life.”)

First a bit of background. When I started the blog in February I focused on the sharp collapse in the economy after the failure of Lehman in mid-September. I argued that the stock market crash of early October 2008 reflected a loss of confidence in the Fed’s willingness and/or ability to maintain adequate NGDP growth going forward. But many readers found this “errors of omission” argument unconvincing. Monetary policy looked accommodative, and it seemed implausible that it was the Fed’s fault for not immediately staunching the bleeding from the financial crisis. Surely the causation went from financial crisis to falling AD. Perhaps the Fed didn’t do enough to offset this shock, but (so the argument went) they can hardly have caused the problem.

A few months later I discussed 7 pieces of evidence that monetary policy was effectively tightening even before Lehman failed, and the economy was weakening. But even here there were two big problems:

1. The phrase “effectively tightening” is only convincing to those who buy into my forward-looking view of monetary policy. The Fed didn’t actually seem to do anything contractionary, like raise the fed funds target.

2. Yes, individual sectors such as industrial production began a sharp decline in August, and the housing downturn also got much worse around that time, but as this USA Today story shows, real GDP declined only 0.3% in the 3rd quarter. That’s not great, but it’s not much different that the 2007.4 or 2008.1 numbers. So why did the financial crisis get much worse in the 4th quarter?

In the past few days I have received answers to both of these questions. The Hetzel article I linked to earlier has an excellent discussion of how Fed policy went off course in the all important third quarter of 2008. I plan an in depth discussion of that evidence in a few days. But last things first. It is much easy to answer the second question, and the answer is about as clear and unambiguous as you can imagine.

When I read the initial news reports on the 2009 second quarter GDP this morning, I was intrigued by a comment that the BEA had also sharply revised the data for 2008 downward. I had been puzzled by the fact that so many individual sectors did very poorly in 2008:Q3, and yet the overall number wasn’t that bad. Is it possible that the revisions would be concentrated in that pivotal quarter? Take a look at the real GDP numbers in this revised GDP report. The new third quarter RGDP number was revised from negative 0.3% to negative 2.7%.

I should mention for those that don’t follow national income accounting closely (in other words normal people), that this number is worse than it looks, indicative an economy than is doing poorly. One has to remember that unlike highly cyclical sectors like industrial production, GDP includes a huge services component (health, education, government, etc) that is relatively stable. So if RGDP goes from the normal 3.0% growth to a negative 2.7%, you are in a serious recession. Yes, the next two quarters were much more horrific (around negative 6%) but that is very atypical of postwar US recessions. Also note that 2008:Q3 was the worst quarter of the recession for consumption. (I wonder if that led to inventory depletion in Q4—the data is not reported.)

The bottom line is that we now know that the economy got much worse before the financial crisis worsened (post-Lehman.) And the study by Hetzel strongly suggests that Fed policy errors during the 3rd quarter went beyond mere “errors of omission.” All the pieces are now in place. We have a plausible story of how excessively tight money in the third quarter led the a worsening of the financial crisis in late September, and also how the Fed’s failure to aggressively ease monetary policy in early October (focusing instead on ineffective bank bailout programs) caused asset prices to crash and accelerated the economic slump.

My next post will discuss how Milton Friedman’s policy ideas were influenced by Robert Hetzel. I mention it now in case non-economists reading this post are tempted to dismiss Hetzel as some minor figure who can safely be ignored. I also plan a very controversial piece on inflation and the first of many China posts in the lead up to my trip.

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About Scott Sumner 492 Articles

Affiliation: Bentley University

Scott Sumner has taught economics at Bentley University for the past 27 years.

He earned a BA in economics at Wisconsin and a PhD at University of Chicago.

Professor Sumner's current research topics include monetary policy targets and the Great Depression. His areas of interest are macroeconomics, monetary theory and policy, and history of economic thought.

Professor Sumner has published articles in the Journal of Political Economy, the Journal of Money, Credit and Banking, and the Bulletin of Economic Research.

Visit: TheMoneyIllusion

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