By Richard Alford, a former economist at the New York Fed. Since them, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
Evaluating the recent performance of the Fed is not a straight forward exercise. The turmoil in the financial system, the recession, the law-bending actions of the Fed in support of certain financial institutions, the decision by the Fed to become involved in the allocation of credit, as well as becoming embroiled in partisan political issues confirm the obvious: there is much more to central banking than setting the cost of overnight money. Any accurate assessment of Fed policy and how we got where we are today will certainly be more involved and less clear cut than the standard assessment based on comparing the actual course of the Fed Funds rate to that deemed appropriate by the chosen variant of the Taylor Rule.
However, the costs of the current recession must receive a significant weight. The ultimate goal of Fed policy has been and remains sustained trend growth with full employment, or equivalently minimizing the opportunity costs associated with “lost” output, idle and misallocated resources experienced during recessions.
Inflation targeting was adopted to reduce deviation from full employment. However, the opportunity costs associated with the deleveraging of the financial system and the economy since the recent asset bubbles burst will very likely exceed the costs experienced during the post-inflation recessionary period of 1980-1983. The current Fed through errors of omission (failure to adequately exercise its regulatory and supervisory responsibilities) and commission (keeping short-term interest rates too low for too long) made policy errors that will prove to be more costly than the inflation inducing policy errors made by the Burns and G William Miller Feds.
In addition, the Fed has allowed itself to become enmeshed in a jury-rigged system by which it decides which firms are allowed to live or die, and in the micro management of the allocation of credit and liquidity by type of counterparties, type of collateral and market. The Fed is now actively and directly engaged in the redistribution of wealth. It is impossible to assess the exact size of policy induced wealth redistributions that result from either the inflation of the 1970s or from Fed policy since 2000 with anything like precision. However, it is possible that recent policy induced wealth transfers from taxpayers and households to financial institutions are of the same order of magnitude as the intersectoral wealth transfer of the 1970s.
In the Charts below, the opportunity costs of the post-inflation recession(s) starting in 1980 and the recession of 2007 are compared. These costs are dattributable to lost output, underemployment of resources, misallocation of resources. The CBO economic forecast will be used for the years 2009-2012. (This forecast assumes a V-shaped trough. Readers, who believe this scenario to be optimistic, are free to substitute a recovery profile of their own choosing).
Lost Output and Idle Resources
An examination of the output gaps during the 5 years preceding and following the cycle peaks in 1980 (including the subsequent double dip recession) and 2007 (assuming CBO forecasts for 2009-2012) suggests the current loss of output as a Percentage of GDP will exceed output loss experienced during the Volcker years. (The output gap is calculated as (real GDP-Potential GDP)/Potential GDP. Real GDP is from the BEA plus CBO forecasts for 2009-2012). “Potential output” is the CBO estimate of potential output.
A quick examination of the labor market and capacity utilization leads to a similar result. Comparing excess unemployment (the average actual unemployment rate for each year (including the CBO forecast for 2009-2012) minus the CBO estimate of the average natural rate for each year.) reveals that more labor resources (as a percentage of the labor force) will be wasted/idle post 2007 than were post 1980. So it appears that unwinding of the asset price bubble will be costly in terms of idle labor resources than was the unwinding of the inflationary economy of the 1970s.
A chart (courtesy of the St Louis Fed) also indicates that the trough in the capacity utilization rate is already well below that reached 1983. Given the shallower recoveries of both output and the unemployment rate forecasted by the CBO, it safe to assume that the CBO also anticipates a slower than normal rebound in capacity utilization.
Misallocation of Resources
Another cost associated with the inflation of the 1970s was channeling of invest into residential construction as households attempted to insulate themselves from the cost of inflation by buying real assets financed with fixed rate mortgages. As the charts below indicate, the asset price bubble 2000-2007 resulted in more resources as a % of GDP being allocated to residential investment than occurred during the inflation bubble of the 1970s.
Perhaps more telling is residential investment as a % of total investment. As a fraction of investment, residential construction in 2006 was approximately 125% of the peak of its peak in 1977.
The relatively quick decline from the peak in 2006 suggests that much of the investment in residential real estate was speculative in nature. The declines in real estate prices also imply that more investment capital (absolutely and relatively) was misallocated to residential construction in 2002-2006 than in the inflationary 1970s. To the extent that residential investment replaced real investment and drove increased debt supported consumption, US productivity, competitiveness, and incomes will suffer more in the future.
In addition to the costs of idled and misallocated resources, there is another dimension to the disruptions caused by both inflation and asset bubbles and their collapse. Wealth is redistributed by both unanticipated inflation and Fed decisions to manipulate markets and prices for various classes of assets. Unlike “lost output” or idle resources (assuming away from definitional and relatively small scale measurement problems), it is impossible to directly observe and measure the redistributions.
Doepke and Schneider (in Doepke and Schneider, Inflation and the Redistribution of Nominal Wealth, Journal of Political Economy, 2006, vol. 114, no. 6) devised a framework within which they simulate the redistributional effects of an unanticipated inflation over a ten year period. . The framework assumes a number of stylized “facts” based upon the US experience of the 1970s. The scale of the inter-sectoral redistrbutional gains and losses generated by the model and the standardized inflation “shock” vary considerably over time. In the mid-1950s, the model indicates that standardized shock would generate a wealth transfer from Households to Government in excess of 10% of GDP. By 1970, it would have been about 4% of GDP. By 1980, it would have been about 1% of GDP. The estimated inter-sector transfer reversed course and increased in absolute size till 1985. However, from about 2000 on, the simulations suggest that both the Household sector and the Government sector would have enjoyed net gains from the inflation induced redistribution of wealth. The “Rest of World” sector which had been quantitatively unimportant as late as the early 1980s was the “simulated” sole net loser to the tune of about 6% of GDP. This may help explain why some foreign holders of US debt have become more interested in US monetary policy as of late. They may perceive US policymakers as more willing to tolerate inflation than it has been recently since a higher proportion, if not all, the net losses will be borne by non-nationals.
The wealth redistribution driven by the recent bubbles was very different than that of the inflation-driven redistributions. The inflation-driven wealth redistribution was driven by a single readily observable factor: inflation. The wealth redistributions of the 1990s and 2000s were driven by a vast array of rollercoaster rides in relative prices. The asset price inflation was characterized by non-uniform changes in various prices, e.g. real estate and various forms of financial assets. The bursting of the asset bubbles has been followed by an explosion government involvement in the financial markets. This includes support for various private sector industries, institutions and various classes of people (e.g. certain home owners, certain home buyers, investors in particular firms, and owners of selected assets including “clunkers”.) The bursting of the asset bubble has result in transfers of wealth from the government sector (taxpayers) to the private. The growth in real debt and contingent obligation of the Federal government and its agencies in part reflects these transfers of wealth. .
Some of the transfers are simply impossible to estimate. However, an estimate of one component is just a few assumptions way from being “ballparkable”. The Fed has cut short-term rates to near zero with an eye to among other things allow financial institution that borrow short and lend long a chance to” earn” their way back to financial health and resume “normal” lending. This represents a transfer wealth from depositors and holders of short-term investment vehicles to those institutions which borrow short to lend long. The scale of the wealth transfer in terms of a % of GDP can then be “guestimated”. Given a chosen measure of short-term assets (as a % Of GDP); an estimate on how much lower on average the interest paid on those instruments is than it would “normally”: and ) the length of time that the Fed will be holding short-term rates at artificially low levels. Given the Dollar volume of outstanding short-term paper and the likelihood the money market rates will remain substantially below where they would have been in the absence of the crises, it seems likely that policy induced transfer from savers to the financial institutions post 2007 will be of the same order of magnitude of net wealth transfer that occurred between households and the government sector in the 1970s.
Your choice, the current Fed: 1) actively promoted the asset bubbles which precipitated the most costly business downturn since the Great depression; 2) passively sat by ignoring its regulatory and supervisory responsibilities allowing the growth of imbalances that led to the worst business downturn since the Great depression; or 3) both of the above. The US did not experience a significant acceleration in the rate of inflation (thanks to globalization) between 200 and 2007. However, the economic and financial imbalances that built up between 2000 and 2007 will generate the opportunity costs in terms of lost output and idle and misallocated resources that will exceed the costs inherent in the economic and financial imbalances reflected in the most expensive anti-inflation fight ever fought by the Fed (1980-1983). The US financial system remains on life support. Furthermore, the Fed has played a part in allocating credit and in engineering redistributions of wealth on a scale that is likely to on the same scale as the redistribution of wealth from the household sector to government during the inflation ridden 1970s. The independence of the Fed has been compromised. Many in the Congress want to audit the Fed and limit its ability to make loans in future emergencies. The Fed is seen by many as an agency of the Treasury. Defenders of the Fed are quick to note that it could have been worst: we could have experienced another Great Depression.
In 1980, the then current Chairman, G William Miller, resigned. Bernanke publically campaigned for and was nominated for a second term.