Tuesday, April 3, 2012

John Taylor and the "Great Recession"

This morning, I read the blog post Policy Failure and the Great Recession by John Taylor.  He argues that the Great Recession (aka the Little Depression) was caused by (a) interest rates that had been "too low for too long" in 2003-05, followed by (b) overshooting "the needed increase in interest rates, which worsened the bust".  Just for illustrative purposes, I'll juxtapose the BEA's estimate of Real Gross Domestic Product from 2002 until the present and Potential Real Gross Domestic Product estimated by the Congressional Budget Office.

To me, the Real GDP and Potential Real GDP seem very close in his "too low for too long" time period.  Okay, but that does not necessarily mean that he is wrong, if expenditures were misdirected by "too low" of interest rates.  Honestly, though, I'm not buying his "too low for too long" argument because if interest rates were much higher, then Real GDP probably would have been below its estimated potential for much of the period.  Clearly there was something unsustainable going on in the housing market, but is the "cause" too low of interest rates or was it the "innovation" (nice euphemism) that resulted in bad loans being passed off as sound securities in Wall Street (by tranching, cutting up a large quantity of loans into securities with different levels of risk).  To me, the answer is probably not "too low too long".

Mr. Taylor implies that what sent the market tumbling is a change (rise) in the interest rates.  Let's try looking back and forth between the previous graph and this next one, which shows the Effective Federal Funds Rate (daily) for the same periods.

It is very clear that the Federal Funds rate was highest from sometime in 2006 through just before 2008, when the Federal Reserve began cutting rates.  But real GDP only reached potential by the early part of 2008.  That is some slow-acting tight(er) monetary policy!  Maybe there is a monetary answer to the "Crisis of 2008", but if there is, I'm not so sure about Mr. Taylor's story.  One more thought.  If Mr. Taylor instead means that the "rate increase" made a bad situation worse, that sounds plausible, but, looking at the data, the "overshooting" of interest rates happened much earlier and was being reversed before the capital crisis (reviving an old term?).


  1. I like this post, but I wonder about a GDP that is above potential GDP. What?

    How can we be above potential? Or do we underestimate potential, as we underestimate how hard people will work and invest in boom times?

    I can remember the 1990s boom times, and the real estate boom of the 2000s. People in some sectors worked seven days a week (happily) for the big money, not to survive, as they do now.

  2. Potential GDP is basically a measure of how high GDP would be to achieve full employment. Full employment is a technical measure that does not correspond to 0% unemployment, but a bit above 5% according to the Congressional Budget Office's estimates.

    Well, as you can see from the graph I produce in the post, the U.S. economy is likely pretty far from a full employment level of production.