VoxEU Column Macroeconomic policy

Misdiagnosing the crisis: The real problem was not real, it was nominal

Do most macroeconomists hold views of this crisis that are entirely at variance with modern monetary economics? This column says that tight monetary policy caused the crisis. Economists seem not to believe what they teach about the fallacy of identifying tight money with high interest rates and easy money with low interest rates.

Here is a puzzle. Almost everything we have learned from recent research in monetary history, theory, and policy points to the Federal Reserve as the cause of the crash of late 2008. More specifically, an extremely tight monetary policy in the US (and perhaps Europe and Japan) seems to have sharply depressed nominal spending after July 2008. And yet it is difficult to find economists who believe this. More surprisingly, few economists are even aware that their views conflict with the standard model, circa 2009.

In this column, I will not try to describe my view of the crisis but rather argue that there is a puzzle that needs to be addressed – why do most macroeconomists hold views of this crisis that are entirely at variance with modern monetary economics?

Was monetary policy tight in late 2008?

Let’s start with my argument that money was very tight in late 2008. Most economists have assumed that the Fed adopted a policy of extreme ease in late 2008. Perhaps so, but I have yet to see a persuasive argument for this assumption. Some would point to the fact that the Fed cut its target rate to very low levels in 2008. Is that reasoning any different from when (in 1938) Joan Robinson argued that easy money couldn’t have caused the German hyperinflation, as interest rates in Germany were not low?

Surely in the 21st century we aren’t still using nominal interest rates as an indicator of the stance of monetary policy? Friedman and Schwartz (1963) demonstrated that interest rates are a very poor indicator on monetary policy. In the early 1930s, the Fed cut its discount rate just as sharply as in 2007-08, and yet today almost no one believes money was easy during the Great Contraction.

Mishkin’s best-selling monetary economics textbook teaches our students that:

“It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates.”

Do we actually believe what we teach our students? When Japan hit the zero rate bound in the late 1990s, there was a similar perception that “easy money” had failed to boost aggregate demand. Friedman’s reaction suggests that the profession was still as confused as Joan Robinson:

“Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. . . . After the US experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.” (Friedman 1997)

Real versus nominal interest rates

At this point some economists will say, “Yes, nominal rates can be misleading, but real rates are a pretty good indicator of monetary problems.” There are problems with this view.

  • First, it is not necessarily true in theory. Robert King (1993) showed that, in a forward-looking rational expectations model, easy money can raise both nominal and real interest rates.
  • Second, if real rates are the “right” monetary policy indicator, then monetary policy became extraordinary tight in late 2008. The only objective estimate of ex ante real interest rates that we have – the spread between the yields on conventional and indexed bonds – soared dramatically between August and November 2008.
Quantity measures of monetary policy

The next line of the monetary-policy-was-loose argument points to the monetary base, which doubled in late 2008. But monetary history teaches us that the base is also an unreliable indicator of policy. The base rose sharply between 1930 and 1933, and yet nominal GDP fell roughly in half.

Even worse, most economists ignored the Fed’s 6 October 2008 decision to start paying interest on reserves – which meant the Fed bribed banks to hoard all the extra liquidity they were injecting into the system. If this sounds unfair, consider that the Fed itself indicated that these payments were necessary to prevent market interest rates from falling; an explanation that Woodward and Hall (2008) correctly described as “a confession of the contractionary effect.”

The Fed’s decision to double reserve requirements in 1936-37 is often cited as a contractionary mistake that prolonged the Depression. The 2008 decision to pay interest on reserves had the same effect, increasing the demand for reserves. Surprisingly, few economists seemed to notice the parallels with 1937, despite the fact that in 2009 nominal GDP is expected to fall at the fastest rate since 1938. I have argued that the Fed should instead charge a penalty rate on excess reserves, and the Swedish Riksbank recently adopted this strategy.

But what about the broader monetary aggregates that increased in 2008? If we learned anything from the 1980s, it is that the broader aggregates are no more reliable than the base. During financial turmoil, it is not surprising that there is an increased demand for safe, FDIC-insured bank deposits.

What are reliable indicators of monetary policy?

Mishkin’s text suggests one indicator: “Other asset prices besides those on short-term debt instruments contain important information about the stance of monetary policy.” How did those other asset prices perform during the crucial period from July to November 2008?

  • The stock market crashed.
  • Commodity prices crashed.
  • Yields on indexed bonds soared.
  • The conventional/indexed bond yield spread went negative.
  • The dollar soared against the euro.
  • The housing crash spread from the sub-prime markets to heartland cities where prices had held up relatively well in late 2007 and early 2008.

This last point deserves emphasis. There were actually two housing crashes. The first (in 2007 and early 2008) was concentrated in markets heavily affected by speculation. The second was nationwide, exactly what one would expect from a monetary policy tight enough to sharply reduce nominal GDP.

To summarise – six asset markets provide six indicators of monetary policy being far too contractionary for the needs of the economy. So if we are going to take seriously what we teach our students in monetary economics classes, then money was exceedingly tight in late 2008.

When did the Fed lose credibility?

Recent research by Svensson (2003) and others has emphasised the importance of “targeting the forecast.” Thus the Fed should adopt a policy stance expected to produce on target growth in their preferred indicator of demand. This might be 2% inflation, or 5% nominal GDP growth. Policy is credible when markets expect the Fed to hit its target. Policy would be too contractionary if the Fed set an explicit 2% inflation target, but markets expected 1% deflation. Svensson argues that central banks should ease or tighten policy as much as necessary for their own internal forecast of inflation to equal the inflation target.

When did the Fed lose credibility? It depends on which forecast you think they should target. I have argued that the Fed should target market forecasts, in which case policy was too contractionary by mid-September 2008, when market forecasts for inflation and real growth were both very low. Indeed Hetzel (2009) argued policy was already too tight in August 2008. If we use the Fed’s internal forecast, policy lost credibility in October 2008. By then, even the Fed acknowledged that medium-term inflation and real growth would be much lower than any plausible estimate of the Fed’s implicit target.

But isn’t monetary policy irrelevant with zero nominal interest rates?

Another point to address is the belief that monetary policy cannot be a cause of the crisis since monetary policy is ineffective when nominal rates are (near) zero bound. This is simply a misunderstanding of modern macro. To quote Mishkin’s textbook:

“Monetary policy can be highly effective in reviving a weak economy even if short-term interest rates are already near zero.”

And once again monetary history provides important lessons. Conventional open market purchases failed to significantly boost nominal spending in 1932, but in the first four months after FDR set an explicit price level target in 1933, nominal spending soared at the fastest rate in US history. And this occurred despite the fact that much of the US banking system was shut down for months. There is no evidence that a financial crisis prevents monetary stimulus from boosting nominal GDP. Ironically, an important paper documenting the success of FDR’s policy – Eggertsson (2008) – was published in September 2008, the very month that monetary policy errors led to the crash of 2008.

The Fed’s failure

Woodford (2003) emphasised how expectations of future monetary policy and aggregate demand impact current demand. An explicit price level or nominal GDP trajectory going several years forward would have helped stabilise expectations in late 2008. Because the Fed failed to set an explicit target path (level targeting), expectations became very bearish in late 2008. Contrary to what many economists assumed, tight money was already sharply depressing the economy by August 2008. After the failure of Lehman most economists simply assumed that causation ran from financial crisis to falling demand. This reversed the primary direction of causation – as in the Great Depression, economic weakness worsened bank balance sheets and intensified the financial crisis in late 2008.

We need to pay attention to what the markets are telling us

A recent Vox column by Carmassi, Gros, and Micossi expressed the widely held view that the roots of this crisis lay in overly accommodative Fed policy during the housing bubble. Policy was a bit too easy during that period, as nominal GDP growth was slightly excessive, but if we are going to take market efficiency seriously then the primary cause of the severe worldwide recession should have occurred when the markets actually crashed. Yes, the tech and housing bubbles showed that markets are not always efficient. But that is no reason to ignore market signals.

On my blog, I have argued that the simultaneous declines in stocks, commodities, and industrial production during late 2008 were eerily similar to late 1929 and 1937. All three crashes occurred as monetary policy errors led investors to dramatically scale back their forecasts for nominal growth going several years forward. Each market crash was followed by one of the most severe contractions of the past 100 years. It is difficult to overstate the importance of maintaining policy credibility with explicit target trajectories for prices or nominal GDP.

The challenge to the profession

Economists need not agree with my view that tight money caused the current recession. But they do need to find counterarguments that do not rely of assumptions that have been thoroughly discredited by recent developments in monetary economics. Fed policy generally reflects the consensus view of elite macroeconomists. If I am right, it was a massive intellectual failure within the economics profession, not reckless bankers, that caused the crash of 2008. This was a failure to trust our own models.

Author’s note: I have benefited from discussions with William Woolsey, David Glasner, and Earl Thompson, who each independently reached many of the views discussed here.


Carmassi, Jacopo; Gros, Daniel; and Stephano Micossi (2009). “Simple explanations for global financial instability and the cure: Keep it simple.” VoxEU.org, 13 August, 2009.
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