“The Great Recession: Market Failure or Policy Failure?”

CentralBanking.com. 13 December 2012

Written by Robert L. Hetzel. Cambridge University Press, 2012, 384 pages.

This is a hugely important book, which should be read by all central bankers, bank supervisors, politicians, and newspaper editors.  It probably won’t be, because it contradicts the firmly held views of most of them.   But that is a great tragedy because Dr Hetzel makes a strong case that much of the policy reaction to the Great Recession is not only not very productive, it is actually counter-productive because based on a total misunderstanding of the causes of the crisis. 

The public consensus in most countries is that the Great Recession was caused by “Wall Street”, by greedy bankers who took outrageously large risks gambling with other people’s money, confident that if things worked out well they would make themselves and their shareholders very wealthy, while if things didn’t quite go to plan, they would at a minimum secure large farewell bonuses while the taxpayer bailed out their bank’s creditors.  In this view of the world, the problem was the deregulation of the banking system, particularly that which followed the repeal of the Glass-Steagall Act in 1999 and the resultant green light given to commercial banks to get into investment banking.  The problem was immoral, and potentially criminal, bankers combined with a total lack of regulation.

Dr Hetzel’s book utterly demolishes this view – indeed, reverses it, and places the blame for the Great Recession firmly on official policy.

He doesn’t pretend that bankers are virtuous, or self-less social workers dedicated to helping the poor and the down-trodden.  Rather he argues that their ability to hold concentrated portfolios of risky assets, largely funded by short-term deposits, was a result of the widespread public perception that large banks, and even not very large banks, were the beneficiaries of the government’s explicit and implicit safety net.  He notes that not since the failure of Continental Illinois Bank in 1984 – when all creditors, insured and uninsured, were protected from loss by the authorities – have the creditors of any significant bank incurred losses in the U.S.

He concludes “that a steadily expanding financial safety net even combined with heavy regulation has increased financial instability.  There is a need for more regulation of the risk taking of banks, but that regulation should come from the market discipline imposed through severe limitation of the financial safety net, especially elimination of [Too Big To Fail]” (p.150).  He concludes his chapter on the U.S. housing crash and the resultant problems in the financial system by stating that the U.S. “still must address whether the flaw that led to excessive risk taking by financial institutions came from a character defect in the form of excessive greed by Wall Street bankers and wilfully ignorant regulators or came from a government-created system that subsidizes the use of leverage to make risky bets” (p.186).

He attributes the severity of the recent recession to faulty monetary policy.  He argues that exogenous shocks – “correction of an excess in the housing stock and a sharp increase in energy prices“ – triggered a recession in the U.S., beginning in December 2007, but argues that those shocks would probably have led to only a moderate recession.  “A moderate recession became a major recession in summer 2008 when the FOMC ceased lowering the funds rate while the economy deteriorated” because of a concern that the persistence of high headline inflation (a result of increased energy prices) “would raise expected inflation above its implicit 2 percent target” (p.204). 

Similar mistakes were made elsewhere, and he asserts that “the severity of the 2008-2009 recession derived from the combined contractionary monetary policy of all the world’s central banks” (p.220).  He notes that “consistent with contractionary monetary policy, core CPI inflation fell after summer 2008 in the major industrial countries.  In both the United States and the Eurozone, core CPI [inflation] fell from 2.5 percent in summer 2008 to 1 percent in summer 2010.  In Japan, core CPI inflation fell from 0 percent in summer 2008 to -2 percent in mid-2010” (p. 221).

In other words, just as flawed monetary policy is now recognised as the main cause of the Great Depression, so Dr Hetzel argues that flawed monetary policy has been the main cause of the Great Recession.

He notes in the Preface to his book that it “runs a horse race between the market-disorder and monetary-disorder views of the most likely causes of recessions, including the 2008-2009 recession” and comes firmly to the view that “the 2008-2009 recession arose because the Federal Reserve departed from a rule that allowed the price system to work” (p.xiv).

I was surprised that I found no reference to the effect on U.S. inflation – and therefore on U.S. monetary policy – of China’s maintenance of a persistently under-valued renminbi over the years prior to the Great Recession, or to the effects on house prices (and therefore indirectly on the riskiness of bank balance sheets) of the tight restraints on the availability of residential land in many of the major metropolitan areas in the U.S.  (Thomas Sowell has noted that 60 percent of all mortgage defaults in the U.S. were concentrated in just five states, primarily those where the supply of residential land was subject to tight restriction.)  Both of these were in my view policy failures which had an influence on economic outcomes over the last decade – though of course in the case of the under-valuation of the renminbi not a policy failure for which the U.S. government was responsible.

But to me he makes an entirely convincing case that the Great Recession was the direct result of significant and widespread policy failures, not caused by either “greedy bankers” or “deregulation”.  The book deserves to be widely read.

Robert Hetzel is Senior Economist and Research Advisor in the Research Department of the Federal Reserve Bank of Richmond and, given his criticism of U.S. monetary policy in recent years, it is a great tribute to the Federal Reserve System that they allowed him to write such a book.

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