Matt Yglesias on the Fed’s deliberations at the height of the housing bubble:

[F]rom the latter part of 2005 through all of 2006 and 2007 and through the beginning part of 2008, the Federal Reserve is basically doing its job correctly. Inflation expectations are remaining stable. Construction workers are losing their jobs, but there’s no broader economic collapse. Many though not all of the construction workers are managing to find employment in other sectors. It’s only in the second half of 2008 that the monetary situation goes haywire, inflation expectations plunge, and the whole economy goes to crap. It then takes a looooong time for expectations to get back to the usual level and when they do so instead of delivering us a spurt of “catch-up” inflation the Fed lets them drop again. More recently, we’ve been back to a more-or-less stable level but with no catch-up. In my view, it’s all that stuff that constitutes the screw-up that the Fed should be lambasted for. The damning transcripts are the ones from late 2008 and all of 2009.

I think this view implies one or more of the following:

- Either the Federal Reserve bears no substantial responsibility for the housing bubble, and therefore the Fed cannot be criticized for allowing the bubble to reach such catastrophic dimensions;

- Or, alternatively, the housing bubble bears no substantial responsibility for the financial crisis, and therefore it doesn’t matter whether the Fed allowed the housing bubble to reach such catastrophic dimensions;

- Or, alternatively, the financial crisis bears no substantial responsibility for the subsequent deep and enduring recession, in which case it doesn’t matter whether the Fed allowed the financial crisis to happen.

Let’s take a closer look at each of these alternatives.

Arguably, bubbles are the unhappy consequence of good management of the nation’s monetary policy. Long periods of low and stable inflation result in a lowered risk premium, and therefore bubbles. Yet another version of this argument would be that bubbles are what we get instead of inflation in a world experiencing a “savings glut.” Bubbles are a feature of an economy increasingly dominated by the capital-owning classes, which in turn is a consequence of rising global wealth and increasing global competition. You can’t blame the Fed for bubbles, because the only way to prevent them would be to have persistently too-tight monetary policy (and consequently persistently elevated unemployment) or a more closed economy (which would mean an absolutely poorer and slower-growing society).

The housing bubble is clearly implicated in the financial crisis – but this fact is worth unpacking a bit. The housing crisis impacted the banking system directly because the banks owned so much structured product that was purportedly risk-free, but that went into free-fall once mortgage defaults began to rise to unprecedented levels, leaving our banks effectively insolvent. But the key question at the time was: were they insolvent, or merely illiquid? That is to say, was the problem that the assets they held were valueless, or was the problem that nobody wanted to pay for them? TARP was originally designed on the assumption that the problem was liquidity – so the government would solve the problem by serving as buyer of last resort for those troubled assets. The Treasury quickly abandoned this plan, however, in favor of bailing out the banks directly. But the point is that the question – solvency versus liquidity – is ultimately a metaphysical one. There is no “real” value for housing, after all, apart from the economic climate that creates a context for that value. As such, one can argue that the bursting of the housing bubble didn’t directly cause the financial crisis – that, rather, what caused the financial crisis was an inadequate policy response to the effectively insolvent condition of the banks’ balance sheets, a response that emphasized preserving the banks as institutions rather than restoring them as rapidly as possible to their proper economic function by cleaning up their balance sheets.

As for the third option, in this view the Fed should remain agnostic as to why inflation expectations go up and down. Its job is simply to keep those expectations on an even keel – and to compensate when they suddenly get out of whack. In this view, the recession was not, in fact, caused by either the financial crisis or the inadequate policy response thereto. Rather, it was caused by the fact that the Fed got scared by the “zero bound” and didn’t keep their eye on the ball: keeping inflation expectations stable. When inflation expectations started to drop, the Fed should have printed money. When they kept dropping, the Fed should have printed more money – committed, publicly, to getting inflation up and keeping it up until the pre-crisis “trend” was reestablished.

If you look at the three propositions together, it becomes clear that there’s a tautological quality to them. The Fed isn’t responsible for the bubble because bubbles are a side effect of successful monetary policy. This implicitly defines “successful” monetary policy without reference to whether we get bubbles, even very large and destructive ones. But, per the second proposition, there aren’t actually any “large and destructive” bubbles, because bursting bubbles only cause great damage if the policy response to the bursting bubble is incorrect – with the right response (one focused on the general interest rather than the interests of incumbents), bubbles are no big deal when they burst. And, finally, even the financial crisis wasn’t the cause of the recession because recessions are always, by definition, caused by the “wrong” Fed policy – by too tight money.

It’s very neat, precisely because it is a tautology. If you assume that the “right” policy response is always an available option, then bad outcomes are caused by policymakers not adopting the “right” policy. But if you assume that people will frequently fail to get the policy response right – whether because they don’t have perfect information, or because they don’t know the “right” response, or because they have preexisting ideological commitments, or because they are always fighting the last war, or because they are subject to pressures from powerful incumbent institutions, or any number of other reasons – and that failure is particularly likely in an atmosphere of crisis, then you have to go back to asking what causes crises in the first place.

An alternative view of the 2000s is that the Fed was propping up an economy that had become unmoored from its own fundamentals. In the wake of the 2000-2002 recession, we did none of the things we should have done to improve the long-term growth prospects for the economy. Instead, we borrowed more and more against ever-rising housing prices. The Fed engineered this bubble because it kept aggregate demand high – and thereby prevented our slipping back into recession after the weak 2003-2004 recovery. The hope – clearly evinced in the 2006 transcripts – was that this recovery had become “self-sustaining” by the time the bubble burst, and therefore a “soft landing” was possible. No such luck; instead we got the financial crisis, a massive reverse wealth effect, a drop in aggregate demand, and the worst recession since the Great Depression.

One response to our current recession is that our most fundamental problem is that the Fed has been too tight. In this view, the economic fundamentals will realign themselves if we get the money supply right. What I keep asking is: isn’t that what we tried a decade ago? We had a bubble, a crash, a recession, and the Fed “did its job” and engineered a recovery. But that recovery was driven not by a proper realignment of economic fundamentals but an asset bubble. Which is why the next crash was worse. Why, if we don’t do something about the economic fundamentals first, won’t a more accommodative Fed have exactly the same result as in the 2000s, only once again even worse?

If the Fed was doing the “right” thing in 2006, in other words, some other organ of government was doing very much the “wrong” thing – because what followed that “right” Fed policy was the biggest crisis of capitalism in nearly three generations.

The problems of economic inequality, poor labor bargaining power, inadequate investment in physical and human capital, over-investment in the unproductive military sector and inadequate productivity in the health-care and education sectors – these are the underlying causes of our extended recession. The recession itself is making these problems worse, by creating a burgeoning class of long-term unemployed that will be a drag on our economy (and a significant human tragedy in and of itself) for years to come. That’s a good reason to be very focused on fighting unemployment directly. But if we ignore those underlying problems and focus exclusively or even primarily on monetary policy, I can’t see why it’ll be more possible to deal with those problems later. And the next crisis, in 2017 or 2022 or whenever, will only be worse.