Back to the future

Federal Reserve Chairman Ben Bernanke was on Capitol Hill today, giving his latest progress (?) report on the economy. The Fed's in a tough spot. You might say it looks like 2003 all over again.

Clearly, the economy's in worse shape than it was in 2003, but the circumstances are similar. There was a jobless recovery underway (unemployment was around 6%), the financial markets were bouncing back from collapse, the budget deficit was growing, and an asset bubble was forming in the real estate and securities markets.

In 2010, we have a jobless recovery, the financial markets bouncing back from collapse, the budget deficit GROWING, and asset bubbles forming in stocks, currencies and commodities.

In 2003, the Fed chose to keep interest rates low to keep the economy from backsliding, to prevent further job losses and to support the confidence building in the financial markets.

In 2010, it's clear the Fed intends to pursue the same policy, reinforced by Bernanke's testimony today:

Although the federal funds rate is likely to remain exceptionally low for an extended period, as the expansion matures, the Federal Reserve will at some point need to begin to tighten monetary conditions to prevent the development of inflationary pressures. Notwithstanding the substantial increase in the size of its balance sheet associated with its purchases of Treasury and agency securities, we are confident that we have the tools we need to firm the stance of monetary policy at the appropriate time.

Let's go back in time to February, 2004 and read an account of Fed Chairman Alan Greenspan's testimony:

At the same time, he promised that, while interest rates would eventually have to rise as the economy expanded, the Federal Reserve could be "patient in removing its current policy accommodation" which has seen rates at a 40-year low.

The Fed has the dual mandate of moving the economy closer to full employment while guarding against price instability. No one said it was easy. Minyanville has a nice explainer and a warning on the Fed's dilemma:

Stock prices incorporate long-term and well as short-term forecasts, and in this regard, it is not at all clear how the Fed is going to be able to prevent a repeat of the 2002-2005 experience in which excess liquidity led to the formation of "bubbles," that later burst with devastating consequences for the financial system and the economy...

Let's hope Bernanke is studying his history as well as he claims to.

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Nice article as usual. I do see some differences though in the comparison to 2003. The housing market had not crashed in the prior time at all, and the jobless rate was low at 6% versus 10% now. So my thought is that while the policy from the Fed looks the same, maybe this time it really works and no real bubbles in assets occur. Even if stocks are too high at some point, we have been through large decreases in stock values in 1987, 1993 etc.. and the economy survived.


SO clear, Tom. I'm always grateful to read your posts. Thanks for doing them. And to Scott for inspiring them.

The Fed's dual mandate was pretty much abandoned in the 1970s with the rise of Friedman's' fanatical monetarism in response to stagflation. This and the U. of Chicago efficient market theorests laid the intellectual basis for policies that increasingly decoupled Wall street from Main street while favoring the former.

The decoupling took off in the 1980s (LBOs), accelerated in the 1990s (CDOs, CLOs, CDSs) and the high tech bubble (fleecing shareholders while destroying wealth and distorting productivity), in the 2000s the housing bubble was used to shift yet more wealth to banks and banksters. In 2007 the financial sector of the American economy accounted for 41 percent of all corporate profits.
See Table 6.16D. Corporate Profits by Industry at:

The Fed, congress and the Obama regime could have helped prevent the credit freeze-up from turning into the Great Recession primarily by attacking the housing problem and letting deleveraging among the TGTF banks take its course. But they choose to transfer wealth to the top banks and banksters instead, to socialize their losses while letting them keep a couple decades of loot. They said this was necessary to get credit flowing again and prevent a recession. Now the Fed is trying to shift its $2 trillion in MBS to Treasury to be paid for by taxpayers.

The era of financial deregulation begun in the late 1970s has produced increasing financial crises of increasing severity (as Minsky more or less predicted). Not only has the Fed abandoned it's full employment mandate but since 1987 it has abandoned its implicit mandate to financial stability, replacing it with a succession of financial bubbles and wealth transfers to the top.

Agreed. Tom is my favorite poster. Even if I were able to organize my thoughts as well as he does, I would surely still shoot my post in the foot with bad grammars.

I am 100% on board with root causes of the crisis and recession as regulatory failures. The question that this poses for me, however, is if the Fed rates being too low were also a prime reason, contributed, or possibly not guilty at all, as Bernanke suggested a few weeks ago.

It makes me wonder if the crisis needed the one-two punch of low Fed rate + deregulation to occur. Would all this have happened with a high rate and 0 regs? Conversely, a low rate with high level of regulation?

Could an economy perform with a high rate with high level of regulation? Seems like it would stifle, but imagine what the APR on a savings account would be!

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