TEN LESSONS FROM THE ECONOMIC CRISIS OF 2008.

• Author: Sumner, Scott B.

During the 1930s, the Great Depression was largely viewed as resulting from a series of financial crises, both domestic and international. Thirty years later, Friedman and Schwartz (1963) reevaluated this period, and discovered that the key problem was an excessively tight monetary policy. The high unemployment, falling incomes, and debt defaults were primarily symptoms of that policy failure, not the fundamental cause of the Great Depression.

In this article, I attempt a similar reevaluation of the Great Recession, focusing on two areas. First, how do we correctly diagnose the nature of a macroeconomic crisis? Second, what policy mistakes were made, and how can we do better next time?

The Real Problem Was Nominal

An important lesson of the Great Recession is the need to correctly diagnose the nature of macroeconomic problems in real time. Throughout history, many macroeconomic problems are seen as "real" problems when they are occurring, and are later diagnosed as nominal problems--too much or too little nominal spending, also known as "aggregate demand."

I have already mentioned the Great Depression, but the same initial misdiagnosis occurred during the Great Inflation of 1965-81, which at the time was attributed to real factors, including labor unions, oil shocks, poor harvests, and budget deficits, and only later attributed to monetary policy failures that allowed inflation to climb from less than 2 percent to more than 10 percent.

Whenever there is a dramatic rise or fall in nominal spending, it is almost always a failure of monetary policy. Thus in 2008-09, the rate of growth of nominal GDP fell from the roughly 5.4 percent trend rate of the previous 17 years, to -3 percent. This led to sharply higher unemployment, and dramatically worsened a financial crisis that had already begun in the previous year.

At the time, the consensus of the economics profession was that monetary policy was roughly appropriate. This mistake was driven by two examples of what I call reasoning from a price change. The phrase refers to the common error of drawing implications from the change in a price without first considering whether the change was driven by supply-side or demand-side factors. Thus, someone might expect high oil prices to lead to less oil consumption, without first considering whether the higher oil prices were caused by less oil supply or more oil demand. If prices were driven up by more demand for oil, then the economy would see more consumption.

Unfortunately, reasoning from a price change is especially common in the field of macroeconomics. During mid-2008, inflation rose well above the Fed's (implicit) 2 percent target. (1) At the time, the Fed interpreted the high inflation as an indication that the economy was in danger of overheating. In mid-September 2008, for example, the FOMC cited the fear of high inflation as a reason not to cut interest rates in the first policy meeting after Lehman failed. In fact, the economy was already nine months into the worst recession since the 1930s, and the actual problem was too little nominal spending, not too much. Instead of focusing on an unreliable indicator such as the inflation rate, the Fed should have looked at nominal GDP (NGDP) growth, which slowed sharply in the first half of 2008, even as inflation was rising.

Another common type of reasoning from a price change occurs when policymakers and pundits wrongly assume that the level of interest rates is a good indicator of the stance of monetary policy. Interest rates did gradually decline throughout 2008, and this was widely viewed as an indication that monetary policy was easing. More recent studies indicate, however, that the natural rate of interest was falling even more rapidly, which meant that policy was effectively tightening. (2)

Even before the Fed was created in 1913, interest rates often moved up and down with the business cycle. Thus the Fed is obviously not the only factor determining the level of interest rates. People get confused on this point because on a day-to-day basis the Fed often targets the overnight rate on interbank loans, the fed funds rate. What they miss is that the Fed tends to accommodate movements in the business cycle, so while a falling fed funds rate might indicate monetary easing, it also might indicate a weakening economy, with Fed rate cuts merely reflecting the economic slump. This is especially problematic if the Fed doesn't fully accommodate the fall in the natural rate of interest, as in 2008. In that case, policy was actually tightening even while the public and many policymakers assumed it was easing. (3)

Another mistake was to focus on some very real economic problems that accompanied the Great Recession, and assume that those problems had caused the recession. Two that stand out were the housing bubble and bust, and the subsequent banking crisis.

The housing boom of 2000-06 is...