The Federal Reserve and the Financial Crisis
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Things were not to remain completely trouble-free, however. Starting in the mid-1960s, for a variety of reasons that I will discuss, monetary policy became too easy. And after a time when the Fed did not change its policy stance, this easy monetary policy led to a surge in inflation and inflation expectations. Figure 7 shows a graph of inflation. You can see that from 1960 to 1964, inflation averaged only a little over 1 percent per year. It picked up during the Vietnam War period, 1965 to 1969, and went even higher in the early 1970s. By the end of the 1970s, the consumer price index (CPI) inflation rate peaked at about 13 percent. Inflation was a growing problem starting in the mid-1960s and into the 1970s.
Why was monetary policy so easy as to allow inflation to become a problem in the 1970s? One issue was technical: monetary policy-makers became too optimistic about how hot the economy could run without generating inflation pressures. It was a general view that unemployment could be kept at a low level, 3 or 4 percent. By keeping inflation a little bit higher, you would be able to get that higher employment level. In the prosperity of the 1950s and the early 1960s, the Fed began to follow that approach. There was actually quite a subtle issue here, which was that economic theory and practice in the 1950s and early 1960s suggested that there was a permanent trade-off between inflation and employment, the notion being that if we could just keep inflation a little bit above normal, we could get permanent increases in employment and permanent reductions in unemployment. That view was taken by many economists during that time.
Figure 7. Consumer Price Index (CPI) Inflation, 1960–1964 to 1980
Note: Percentage change calculated from end-of-period to end-of-period. Source: Bureau of Labor Statistics
Milton Friedman, the famous monetary economist, wrote in the mid-1960s quite prophetically that this was going to cause trouble. He argued that an increase in inflation might cause unemployment to fall for a while but at best it would be a transitory effect. The analogy might be to a candy bar: if you eat a candy bar, in the short run it gives you a burst of energy, but after a while, it just makes you fat. Friedman argued, and he turned out to be quite prescient, that attempts to keep unemployment too low through monetary policy were going to end up creating inflation.
Today, it is still debated whether political pressures were put on the Fed to keep monetary policy too easy during that period. After all, this was another period of government deficits, as the government was trying to finance the Vietnam War and the Great Society. That may have influenced the Fed’s behavior as well.
You cannot have sustained inflation without monetary policy being too easy. In another famous quote Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Nevertheless, a bunch of exacerbating factors made the problem worse and made it more difficult for the Fed to offset the increase in inflation. First, there were a number of shocks to the prices of oil and food. A very striking example occurred in 1973. In October 1973, the Yom Kippur War in the Middle East broke out. In retaliation against U.S. support of Israel, OPEC (Organization of the Petroleum Exporting Countries) used its cartel power to embargo oil exports. Over a short period in the early 1970s, the price of oil almost quadrupled, causing a very sharp increase in gas prices. People were lining up at gas stations to fill their gas tanks. There was a system of even-odd rationing. If your license plate had an even number, you could go to the gas station only on Tuesdays and Thursdays. If it had an odd number, you could go only on Mondays and Wednesdays. It was a very serious issue and there was a lot of unhappiness about gas prices then (as there is today).
Fiscal policy overall was too loose during the late 1960s and early 1970s. The Vietnam War and other government programs increased government spending and increased deficits, which put additional pressure on the capacity of the economy.
Another element that I will mention briefly is wage-price controls. When inflation got up to about 5 percent in the early 1970s, President Richard Nixon introduced wage-price controls, a series of laws that forbade firms from raising their prices. There were exceptions, and there were all kind of boards to try to find exceptions. It was basically a very unsuccessful policy. As you know, prices are the thermostat of an economy. They are the mechanism by which an economy functions. So, putting controls on wages and prices meant that there were shortages and all kinds of other problems throughout the economy. But in addition, as Milton Friedman put it, this was like dealing with an overheating furnace by breaking the thermostat. The fundamental problem was the fact that there was too much aggregate demand driving up prices, and simply passing a law that forbade raising prices did not address the underlying problem of excessive monetary ease and excessive demand. So, wage-price controls kept inflation artificially low for a couple of years, which made it harder for the Fed to figure out what was going on. When the wage-price controls finally collapsed in disarray, because they were creating so many proximity problems in the economy, inflation surged, like a spring that was released. So there were a lot of causes for the increase in inflation.
Arthur Burns, who was the chairman of the Fed during the 1970s, said, “In a rapidly changing world, the opportunities for making mistakes are legion,” which is certainly true. One way to think about this whole episode is that after World War II and the end of the Depression, and with the prosperity they saw, economists and policymakers became a little bit too confident about their ability to keep the economy on an even keel. They used the term fine tuning to refer to the notion that the Fed and fiscal policy and other government policies could keep the economy more or less perfectly on course and not worry about bumps and wiggles in the economy. That turned out to be too optimistic, too hubristic, as we collectively learned during the 1970s when the efforts of policymakers resulted, not in a lower unemployment rate, which was the original goal, but instead in a very sharp increase in inflation. So one of the themes here is that—and this probably applies in any complex endeavor—a little humility never hurts.
There was a reaction to the increase in inflation in the 1970s, and the key person in this period is Chairman Paul Volcker, who remains to this day an influential figure in economic policy discussions. President Jimmy Carter, whose reelection was seriously threatened by the poor performance of the U.S. economy, appointed Volcker to be the new chairman of the Fed. He did so partly because he thought that Volcker was a tough central banker who would do what was necessary to get inflation under control. And Volcker, who stands six feet eight and smokes a big cigar, certainly gave the impression of somebody who was willing to take strong action. Volcker had been in office for only a few months when he determined that strong action was needed to address the inflation problem. In October 1979, he and the Federal Open Market Committee (FOMC), the policymaking committee of the Fed, instituted a strong break in the way monetary policy was managed. Basically, it allowed the Fed to raise interest rates quite sharply. Raising interest rates slows the economy and brings inflation pressures down. As Volcker said, “To break the inflation cycle, we must have credible and disciplined monetary policy.” And it worked. In the years after this program began, inflation fell quite sharply. In Figure 8, you can see that from 1980 to 1983, inflation fell from about 12 or 13 percent all the way down to about 3 percent—a relatively quick decline in inflation that offset the problems of the late 1970s. In that respect, the policies of the 1980s were quite successful: they achieved their objective of bringing inflation under control. Nothing is free, however, and one of the effects of these policies was to raise interest rates quite sharply for consumers and businesses. I had just gotten out of graduate school, and I remember in about 1981 or 1982 looking at the possibility of buying a home and being informed that the rate for a thirty-year mortgage was 18.5 percent. So interest rates were quite high and, as one might expect, that brought down economic activity and effective inflation as well.
Figure 8. CPI Inflation, 1980-1987
Note: Percentage change calculated from end-of-period to end-of-period. Source: Bureau o
f Labor Statistics
In Figure 9, you see the unemployment rate during this period. The high interest rates, which were necessary to bring down inflation, also caused a very sharp recession. The unemployment rate in 1982 was almost 11 percent, even higher than we saw in the most recent recession. So, there were definitely very negative side effects from Volcker’s actions.
As you can imagine, the political pressure on the Fed and on Chairman Volcker was intense. During this period, it was common practice to mail to the Fed bits of two-by-fours. And on the two-by-fours it would say, “Stop killing construction,” or “Save the farmer,” or whatever, because the high interest rates were having very negative effects on the economy. I keep a few of these on my desk to remind me that inflation is a concern and that we always have to pay attention to price stability. But this is also an example of why independence is important. If Volcker had needed to be reelected, perhaps he would not have been able to sustain his policy. Instead, he maintained an independent monetary policy. He received at least sufficient support from President Ronald Reagan and from the Congress to be able to carry through the policy, which succeeded in bringing inflation down.
Figure 9. Unemployment Rate, 1979–1987
Note: Fourth-quarter values.
Source: Bureau of Labor Statistics
During the 1970s, output and inflation were very volatile. We saw how much inflation moved around. There was a pretty sharp recession in 1973–1975 after the OPEC embargo. And then there was more volatility in the early 1980s as Volcker brought down inflation and the economy went into recession.
Volcker left the chairmanship in 1987, and he was succeeded by Alan Greenspan, who held that position for almost nineteen years, from 1987 to 2006. One of Greenspan’s important accomplishments for most of his tenure was achieving greater economic stability. As he said, “an environment of greater economic stability has been key to the impressive growth in the standards of living … in the United States.” There was so much improvement in the stability of the economy that the period has come to be known as the Great Moderation, as opposed to the Great Stagflation of the 1970s or the Great Depression of the 1930s. The Great Moderation was a very real and striking phenomenon. Figure 10 shows the variability of real GDP growth from 1950 essentially to the present. The line shows quarterly growth rates in GDP. So a sharp peak shows an increase in GDP growth and a drop shows a decline in GDP growth. These are quarterly numbers. You can see the bounciness—periods of rapid growth followed by periods of slower growth. The shaded area in the left-hand portion of the graph is a one standard deviation band. Essentially, it is a measure of the average volatility of GDP growth quarter to quarter during the period between 1950 and 1985. You can see that GDP growth was pretty variable throughout the entire period. There was a lot of volatility in the economy. There were a number of recessions, including the severe ones in 1973 and 1981. Now, look at what happens to GDP variability between 1986 and 2007 or so. The variability from quarter to quarter is much less, and the shaded band to the right shows the average variability of one standard deviation for GDP growth in this latter period. It is very striking how much more stable the economy was over this roughly twenty-year period.
This was true not only for real GDP growth; it was also true for inflation. Figure 11 shows basically the same picture. The vertical line in the middle of the graph splits the time period into pre-1986 and post-1986. The graph shows inflation quarter by quarter as measured by the CPI. Again, the shaded bar on the left side of the graph shows one standard deviation average volatility of inflation in the pre-1986 period. You can see the huge spikes in inflation in the 1970s. And then in post-1986, you see much lower volatility. So both growth and inflation were more stable to a quite remarkable extent, which economists commented on quite frequently. That was the so-called Great Moderation.
Figure 10. Real GDP Growth, 1950-2010
Note: Data are quarterly. The shaded areas of the graph show plus and minus one standard deviation around the sample period mean of the data, a common measure of data variability. Source: Bureau of Economic Analysis
Figure 11. CPI Inflation, 1950-2010
Note: Data are quarterly. The shaded areas of the graph show plus and minus one standard deviation around the sample period mean of the data.
Source: Bureau of Labor Statistics
Why was the economy so much more stable between the mid-1980s and the mid-2000s? Lots of research has been done on this question. There is quite a bit of evidence that monetary policy played a role in creating better stability. In particular, even though Volcker’s efforts to bring down inflation in the early 1980s led to a deep recession and a lot of pain in the short term, there was a payoff. That payoff was an economy that was much more stable, with low, stable inflation, more stable monetary policy, and more confidence on the part of business people and households—and that contributed very significantly to broader stability. Remember that Friedman pointed out that there was no long-term trade-off between inflation and unemployment: one could not permanently lower unemployment by keeping inflation a little higher. That is true. But in a different sense, low and stable inflation over a long period makes an economy more stable and supports healthy growth and productivity and economic activity. So low inflation is a very good thing, and the reduction in inflation that occurred in the 1980s was really a global phenomenon. A lot of countries had inflation problems in the 1980s, but all around the world, even developing countries brought down their inflation rates quite considerably, and that has been a positive for economic growth and stability since the mid-1980s.
Not all of the Great Moderation was caused by monetary policy. Other factors no doubt played a role. One is general structural change in the economy. An example would be that, over time, firms have learned how to manage their inventories much more effectively. The practice of so-called just-in-time inventory management is a practice in which, instead of having large stocks of inventory on hand, firms acquire inputs only when they need them for production. Not having large stocks of inventory on hand reduces an important source of fluctuations in the economy because, if demand slows down and you have a big inventory, then you do not do any more production for quite a while until you run down that inventory. Improved management of inventories is just an example (I could cite many others) of better business practices and other factors in the economy that made things more stable. And it may also be the case that there was just better luck—we had fewer oil price shocks and other things happening—and that too may have contributed to the Great Moderation. But as figures 10 and 11 showed, there was quite a striking change in the way the economy operated after the mid-1980s.
Another aspect of the Great Moderation is that there were not any big, damaging financial crises in the United States. There was a stock market crash in 1987, but it did not do much damage. A more significant event was the boom and bust in the dot-com stocks in the late 1990s, and that touched off a mild recession in 2001. But one of the inferences people took away from the Great Moderation was not only was the economy more stable but the financial system seemed more stable as well. As a result, financial stability policies got deemphasized to some extent during this period.
Let’s turn now to the prelude to the financial crisis. One of the key events that led ultimately to the recent crisis was a big increase in house prices. Figure 12 shows prices of existing single-family homes, where January 2000 is indexed to be 100. From the late 1990s until early 2006, house prices across the country increased by about 130 percent. You can see that line going straight up, a very sharp increase in home prices. And as I will discuss, at the same time that was happening or perhaps a little bit later in the process, the lending standards for new mortgages to buy homes were deteriorating. Now clearly, a big part of what was happening to create the housing bubble or the increase in housing prices was psychology. After all, the late 1990s was a period with a lot of optimism about tech stocks and the stock market more generally. And some of that optimism,
no doubt, spilled over into the housing market. So there was an increasing sense that house prices would keep rising and that housing was a “can’t lose” investment. I lived in California for a while, earlier than this but during a period when house prices were rising, and all everybody talked about at cocktail parties was, “What’s your house worth now?” and “How much money are you making on your home?” It made working seem rather unnecessary because all you had to do was keep checking the real estate listings. So there was a lot of excitement and enthusiasm about the fact that house prices were going up and making everybody rich. At the same time that this was happening, the standards for underwriting new mortgages were getting worse and worse, which in turn was bringing more and more people into the housing market and pushing up prices even further.
Figure 12. Prices of Existing Single-Family Houses, 1980–2005
Note: Includes purchase transactions only.
Source: CoreLogic
Let’s talk a bit about mortgage quality. Prior to the early 2000s, home buyers were typically asked to make a significant down payment of 10 percent, 15 percent, maybe 20 percent of the home price. And they had to document their finances (their income, their assets, and so on) in great detail to persuade the bank to make them a loan, which in many cases might be four or five times their annual salary. Unfortunately, as house prices rose, many lenders began to offer mortgages to less-qualified borrowers, so-called nonprime mortgages.3 These mortgages often required little or no down payment and little or no documentation. Essentially, mortgage lenders were moving further down the credit spectrum, lending to more and more people whose credit was less than stellar. You can see this in a number of different ways. Figure 13a shows the percentage of mortgage originations—that is, new mortgages created—that were nonprime (subprime or Alt-A or some other lower-quality mortgage). You can see the very sharp increase, particularly in the middle of the 2000s and 2006. Almost one-third of all mortgages that were originated were nonprime. Figure 13b shows another indicator of the deterioration of mortgage quality: the percentage of nonprime loans with low or no documentation. If you think about it, this is rather perverse. If you are going to make a loan to somebody whose credit is shaky, who does not have a down payment, whose FICO score is low, and so on, one would think you would want to ask them even more questions about their income and their prospects. But, in fact, it went the other way. And as you can see, by 2007, 60 percent of nonprime loans had little or no documentation of the creditworthiness of the borrower. So there was clearly an ongoing deterioration of mortgage quality.