The Courage to Act in 2008

Ben Bernanke’s memoir is now out and is unapologetically pro-Fed. It is titled The Courage to Act. Here is the cover quote:

bernanke, courage to act, 2008 crisis

The main point of Bernanke’s book is that absent the Fed’s interventions over the past seven years the U.S. economy would have undergone another Great Depression. Thanks to him and his colleagues at the Fed the world is a much better place.

There has already been some push back on this Bernanke triumphalism. George Selgin, for example, notes that the recovery under Bernanke’s watch was anemic. Inflation consistently undershot the Fed’s target and the real recovery was weak. We may not have experienced another Great Depression, but we sure did get a long slump. Ryan Avent makes a similar point by observing that Bernanke had a chance in late 2011 to do something bold by endorsing a NGDP target, an action that could have jolted the economy from its doldrums. But alas, Bernanke failed to muster up the courage to have what Christina Romer called his “Volker Moment”.

Expect more push back along these lines from a book with such a bold title. One strand of criticism that many observers miss, but I hope will be considered in future reviews of Bernanke’s book is the role the Fed played in allowing the crisis to emerge in the first place. Could the Fed have done more to prevent the recession from becoming as severe as it did? Maybe a recession was inevitable, but was a Great Recession inevitable? These are the questions first raised by Scott Sumner and echoed by others including me. Our answer is no, the Great Recession was not inevitable. It was the result of the Fed failing to act aggressively enough in 2008.

This understanding draws upon the fact that the housing recession had been going on for about two years before a wider slowdown in economic activity occurred. As seen in the two figures below, sectors of the economy tied to housing began contracting in April 2006 while elsewhere employment growth and nominal income continued to grow. This all changed in the second half of 2008.

So what went wrong in the second half of 2008? Why did a seemingly ordinary recession get turned into a Great Recession? We believe the Fed became so focused on shoring up the financial system and worrying about rising inflation, that it lost sight of stabilizing aggregate demand. Based on theses concerns, especially the latter, the FOMC decided to do abstain from any policy rate changes during the August and September 2008 FOMC meetings. But by doing nothing at these meetings the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed could have responded to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy.

The figures below document this monumental failure by the FOMC. The first one shows the 5-year ‘breakeven’ or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market’s forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

One way to interpret this figure is that the Treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers’ monthly nominal GDP data indicates this is the case:

The Fed could have cut its policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just the change in the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signaling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten.

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have been far less severe and the resulting bankruptcies fewer. Again, the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed.

So had Fed had the courage to act in 2008 the economy would be in a very different place today. Future reviewers of Bernanke’s book should keep that in mind.

P.S. For a more thorough development of this view see the book by Robert Hetzel of the Richmond Fed.

[Cross-posted from]

Court Denies Insider Trading Appeal

This week the New York Times reports that the Supreme Court has refused to review the ruling of the Second Circuit Court of Appeals in the case United States v Newman. The Second Circuit, in December, overturned the insider trading conviction of a pair of hedge fund managers because nothing of value was exchanged in return for the information and thus the managers could not have known that the information they received was improperly disclosed to them by the information source.  The Supreme Court decision would seem to block insider trading prosecutions in the absence of clear financial gains to those who leak the information.

This, in turn, has energized some members of Congress to introduce legislation to make it illegal to trade on insider information regardless of how one obtains it. This standard would define insider trading far more broadly than the standard laid out in Newman, or, for that matter, even before Newman based on the precedent in Dirks v SEC.

In his article in the current issue of Regulation, Villanova University law professor Richard Booth explores the Newman ruling.  He argues that ordinary diversified investors neither lose nor gain from insider trading because they own all stocks and don’t trade very often.  The only investors who have an interest in the prosecution of insider trading are “activist investors – hedge funds and corporate raiders – who stand to benefit from slower reaction times as they buy up as many shares as possible before anyone notices.”  “… [H]edge fund managers have a distinct interest in seeing other hedge fund managers prosecuted for insider trading.”  They rather than ordinary investors are the beneficiaries of insider-trading prosecutions.  Thus ordinary investors should applaud the Newman ruling and oppose the attempts by Congress to adopt a European-style law against all insider trading.

For more Cato work on insider trading, see these links.

Research assistant Nick Zaiac contributed to this post.


USDA/HHS Removes Consideration of “Sustainability” from Dietary Guidelines

The U.S. Departments of Agriculture and Health and Human Services made headlines last winter when they released the draft form of their updated dietary guidelines and revealed that they were considering “sustainability” as a factor in their recommended diet—and by “sustainable” they meant foods that had “lower greenhouse gases” associated with their production. This favors plant-based foods over animal- based ones.

President Obama’s Climate Action Plan now even had its far-reaching fingers in our food. We found this somewhat rude.

Under the wildly-crazy assumption that all Americans, now and forever, were to convert to vegetarianism, we calculated that the net impact on future global warming as a result of reduced greenhouse gas emissions was two ten-thousandths of a degree Celsius (0.0002°C) per year. Not surprisingly, we concluded if one were worried about future climate change, “ridding your table of steak shouldn’t be high on the list.”

TPP Ends Up with Pleasantly Mild Rules on Biologic Drug Monopolies

The Trans-Pacific Partnership will reportedly include an obligation for every country to provide at least 5 years of market exclusivity for new biologic drugs.  Technically, this counts as a loss for U.S. negotiators, who started with a demand for 12, lowered that to 8, reconfigured 8 into “5+3”, and at the VERY last minute—despite direct calls from President Obama to foreign leaders—were forced to acquiesce to 5 years.  The U.S. pharmaceutical industry says it’s very disappointed, but the outcome is good for the TPP and for consumers around the world.

It’s important to recognize that the exclusivity we’re talking about here has nothing to do with patent protection.  It is not a form of intellectual property.  Exclusivity is a regulatory policy that instructs the Food and Drug Administration not to approve generic, unpatented drugs they know are safe so that name-brand pharmaceutical companies can make more money. 

Those companies say that without a secured return on investment, they wouldn’t be able to invent new treatments.  But that’s what patents are for.  Regulatory exclusivity is a way to bypass the balances and limitations of patent law, which only protects new inventions not all expensive investments.  

They complain that it’s unfair for generic competitors to piggyback on all the expensive research and testing they did to secure FDA approval.  But that’s a problem with the expense of FDA approval.  Either lobby to make FDA approval cheaper or find a way to share costs.  Pharmaceutical companies are not entitled to the benefits they gain from regulatory inefficiency.

Biologics protection was a peculiar issue for U.S. negotiators to be spending so much effort on in the first place.  They spent a lot of negotiating capital trying to secure foreign regulations favorable to one part of one U.S. industry.  That doesn’t further the goal of free trade; in fact, it impedes that goal by diverting energy away from universally valuable efforts to open up Canada and Japan’s markets in agriculture.

The U.S. government may have wasted effort on biologic exclusivity, but at least they failed to hobble foreign countries with excessive drug regulation.  As a bonus, Congress is now free (if they wish—and they should) to roll back the 12 years of protection under U.S. law to something more reasonable.

Could Airlander be the Future of Freight?

The airship is making a comeback. Take the British Airlander10, which uses 20 percent of fuel burned by conventional aircraft and can be fitted with solar panels. Airlander can stay airborne for five days while carrying a maximum payload of 20,000 pounds. It is much safer than its 1930’s cousin and can operate in adverse weather. Combined with GPS navigation and tracking, an unmanned Airlander could stay airborne for up to two weeks, carrying cargo vast distances, including hard-to-reach places. The British manufacturer is already working on an airship that could carry up to 100,000 pounds of cargo – roughly equivalent to the payload of two 20 foot containers. A vast fleet of Airlanders moving silently through the air 24/7 could dramatically decrease the cost of transport (they are faster than ships and much more cost effective than aircraft), while connecting places without ports or runways. Find out more about the declining cost of air travel at



Social Security Technical Panel: 75-Year Shortfall Might be 28 Percent Larger

A recent report from the Social Security Advisory Board’s Technical Panel found that the 75-year shortfall could be 28 percent (roughly $2.6 trillion) larger than the estimate in this year’s Trustees Report due to changes in some of the underlying technical assumptions. This disparity is more the product of the difficulties related to projecting the trajectory of a program as large and complicated as Social Security so far into the future, with the chair of the Technical Panel taking pains to reiterate that “the methods and assumptions used by the Social Security actuaries and Trustees are reasonable.” Even so, the report reveals the uncertainty related to the long-term projections for Social Security, with relatively small changes to some of the underlying assumptions significantly changing the program’s financial solvency outlook. Social Security is the largest government program in the world, and changes in its fiscal outlook could have a large impact on the government’s overall finances.

The changes in the Technical Panel report that would have the largest impact are concentrated in a few variables:

  • Higher fertility rate
  • Higher life expectancy
  • Higher interest rates

Other changes to inflation and real earnings growth rate assumptions have a small negative impact, while changes to immigration assumptions slightly improve the program’s financial picture.  Some of the changes reflect developments that are good overall but have a negative impact on Social Security’s finances, like higher life expectancy.


Some of the panel’s recommendations focus on making the methodology of the Trustees’ Report more transparent and the degree of uncertainty more clear.  While it’s possible that unforeseen changes to underlying variables like the fertility rate could improve the program’s financial outlook, it is much more likely that the trillions in unfunded obligations published in the Annual Trustees’ Report understate the shortfall, if anything.


Will TTIP Wilt in the Shadow of the Aging German Voter?

In today’s Cato Online Forum essay, Iana Dreyer of the EU trade news service Borderlex marshals public opinion data to support a rather gloomy prediction about the chances for a robust and comprehensive TTIP outcome. Despite having “strong ‘Atlanticist’ instincts and the vision for Europe as a dynamic, globalized, economic powerhouse,” the EU’s business community and its cosmopolitan policy makers are likely to be thwarted by demographics: especially, by the aging German voter.

Iana concludes that the likely outcome will be a TTIP agreement that reflects the sensibilities of older, risk-averse Europeans who are unwilling to gamble with their social safety nets, even though those safety nets are not really on the negotiating table, which means a rather shallow and limited agreement at best.

The essay is offered in conjunction with a Cato Institute TTIP conference being held on Monday.  Read it. Provide feedback.  And register to attend the conference here.