THE GREAT RECESSION Since publication of Robert L. Hetzel’s h e Monetary Policy of the Federal Reserve (Cambridge University Press, 2008 ), the intellectual consensus that had charac- terized macroeconomics has disappeared. h at consensus emphasized ei cient markets, rational expectations, and the ei cacy of the price system in assuring macroeconomic stability. h e 2008–2009 recession not only destroyed the pro- fessional consensus about the kinds of models required to understand cyclical l uctuations but also revived the credit-cycle or asset-bubble explanations of recession that dominated thinking in the nineteenth century and i rst half of the twentieth century. h ese “market-disorder” views emphasize excessive risk taking in i nancial markets and the need for government regulation. h e pres- ent book argues for the alternative “monetary-disorder” view of recessions. A review of cyclical instability over the last two centuries places the 2008–2009 recession in the monetary-disorder tradition, which focuses on the monetary instability created by central banks rather than on a boom-bust cycle in i nan- cial markets. Robert L. Hetzel is Senior Economist and Research Advisor in the Research Department of the Federal Reserve Bank of Richmond, where he participates in debates over monetary policy and prepares the bank’s president for meetings of the Federal Open Market Committee. Dr. Hetzel’s research on monetary pol- icy and the history of central banking has appeared in publications such as the Journal of Money, Credit, and Banking; the Journal of Monetary Economics ; the Monetary and Economics Studies series of the Bank of Japan; and the Carnegie- Rochester Conference Series . His writings provided one of the catalysts for the congressional hearings and Treasury studies that led to the issuance of Treasury Inl ation Protected Securities (TIPS). Dr. Hetzel has given seminars or served as a visiting scholar at the Austrian National Bank, the Bank of England, the Bank of Japan, the Bundesbank, the European Central Bank, the National Bank of Hungary, and the Center for Research into European Integration in Bonn, Germany. He received his PhD in 1975 from the University of Chicago, where Nobel Laureate Milton Friedman chaired his dissertation committee. Dr. Hetzel is author of h e Monetary Policy of the Federal Reserve (Cambridge University Press, 2008 ). Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Studies in Macroeconomic History Series Editor: M i c h a e l D . B o r d o , Rutgers University Editors: M a r c F l a n d r e a u , Institut d’Etudes Politiques de Paris Chris Meissner , University of California, Davis F r a n ç o i s V e l d e , Federal Reserve Bank of Chicago David C. Wheelock , Federal Reserve Bank of St. Louis h e titles in this series investigate themes of interest to economists and economic historians in the rapidly developing i eld of macroeconomic history. h e four areas covered include the application of monetary and i nance theory, international economics, and quantitative methods to historical problems; the historical application of growth and development theory and theories of business l uctuations; the history of domestic and international monetary, i nancial, and other macroeconomic institutions; and the history of international monetary and i nancial systems. h e series amalgamates the former Cambridge University Press series Studies in Monetary and Financial History and Studies in Quantitative Economic History . Other books in the series: H o w a r d B o d e n h o r n , A History of Banking in Antebellum America [9780521662857, 9780521669993] M i c h a e l D . B o r d o , h e Gold Standard and Related Regimes [9780521550062, 9780521022941] Michael D. Bordo and Forrest Capie (eds.), Monetary Regimes in Transition [9780521419062] Michael D. Bordo and Roberto Cortés-Conde (eds.), Transferring Wealth and Power from the Old to the New World [9780521773058, 9780511664793] Michael D. Bordo and Ronald MacDonald , Credibility and the International Monetary Regime: A Historical Perspective [9780521811330] Claudio Borio , Gianni Toniolo , and Piet Clement (eds.), Past and Future of Central Bank Cooperation [9780521877794, 9780511510779] Richard Burdekin and Pierre Siklos (eds.), Del ation: Current and Historical Perspectives [9780521837996, 9780511607004] Forrest Capie , h e Bank of England: 1950s to 1979 [9780521192828] Trevor J. O. Dick and John E. Floyd , Canada and the Gold Standard [9780521404082, 9780521617062] Barry Eichengreen , Elusive Stability [9780521365383, 9780521448475, 9780511664397] Barry Eichengreen (ed.), Europe’s Postwar Recovery [9780521482790, 9780521030786] Caroline Fohlin , Finance Capitalism and Germany’s Rise to Industrial Power [9780521810203, 9780511510908] (Continued at er index) Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 h e Great Recession Market Failure or Policy Failure? ROBERT L. HETZEL Senior Economist and Research Advisor Federal Reserve Bank of Richmond Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Mexico City Cambridge University Press 32 Avenue of the Americas, New York , NY 10013-2473, USA www.cambridge.org Information on this title: www.cambridge.org /9781107011885 © Robert L. Hetzel 2012 h is publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2012 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication data Hetzel, Robert L. h e great recession : market failure or policy failure? / Robert L. Hetzel. p. cm. Includes bibliographical references and index. ISBN 978-1-107-01188-5 (hbk.) 1. Recessions – United States. 2. Monetary policy – United States. 3. Business cycles – United States. 4. United States – Economic policy – 2009– 5. United States – Economic conditions – 2009– I. Title. HB3743.H48 2011 330.973–dc23 2011038742 ISBN 978-1-107-01188-5 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and does not guarantee that any content on such Web sites is, or will remain, accurate or appropriate. Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:42 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Contents List of Figures page ix L i s t o f T a b l e s xii P r e f a c e xiii 1 . h e 2008–2009 Recession: Market or Policy Maker Failure? 1 2. Recessions: Financial Instability or Monetary Mismanagement? 11 3 . h e Great Contraction: 1929–1933 23 4. Monetary Policy and Bank Runs in the Great Depression 46 5. Vigorous Recovery and Relapse: 1933–1939 65 6. Interwar International Monetary Experiments 85 7. Identifying the Shocks that Cause Recessions 110 8. From Stop-Go to the Great Moderation 128 9. Controlling Bank Risk Taking: Market or Regulator Discipline? 149 10. h e Housing Crash: Subsidizing Housing and Bank Risk Taking 170 11. Bubble Trouble: Easy Money in 2003 and 2004? 187 12. What Caused the Great Recession of 2008–2009? 204 13. What Caused the Great Leverage Collapse? 239 14. h e Distinctions Between Credit, Monetary, and Liquidity Policy 257 15. Fed Market Interventions: h e Experiment with Credit Policy 282 vii Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:48 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 viii Contents 16. Evaluating Policy: What Are the Relevant Counterfactuals? 300 17. h e Business Cycle: Market Instability or Monetary Instability? 319 18. Why Is Learning So Hard? 330 19. How Should Society Regulate Capitalism? Rules versus Discretion 342 Postscript 346 B i b l i o g r a p h y 351 I n d e x 377 Downloaded from Cambridge Books Online by IP 14.139.43.12 on Sat Oct 06 08:32:48 BST 2012. http://ebooks.cambridge.org/ebook.jsf?bid=CBO9780511997563 Cambridge Books Online © Cambridge University Press, 2012 Figures 3.1. Price levels in gold-standard and non-gold-standard countries: 1873–1893 page 35 4.1. h e market for bank reserves 48 4.2. Increase in nonborrowed reserves and decrease in discount rate 49 4.3. Money-market interest rates and regional Fed bank discount rates 50 4.4. M2 growth 51 4.5. Federal Reserve credit and currency held by public: 1928–1940 53 4.6. M2 and total, required and excess reserves of member banks 54 4.7. Change in M2 and deposits of suspended banks 55 5.1. U.S.