What Was the Federal Reserve Thinking in Summer 2008?

A complete chronology of the recent financial crisis might start in February 2007, when several large subprime mortgage lenders started to report losses. It  might then describe how spreads between risky and risk-free bonds—“credit spreads”— began widening in July 2007. But the definitive trigger came on August 9, 2007, when the large French bank BNP Paribas temporarily halted redemptions from three of its funds because it could not reliably value the assets backed by U.S. subprime mortgage debt held in those funds. When one major institution took such a step, financial firms worldwide were encouraged to question the value of a variety of collateral they had been accepting in their lending operations—and to  worry about their own finances. The result was a sudden hoarding of cash and cessation of interbank lending, which in turn led to severe liquidity constraints on many financial institutions.\” 

By August and September 2007, the Fed was already cutting interest rates. By December 2007, the Fed had started creating an alphabet soup of temporary agencies for making emergency loans as needed: Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), Primary Dealer Credit Facility (PDCF), Commercial Paper Funding Facility (CPFF), Term Asset-Backed Securities Loan Facility (TALF). The unemployment rate was climbing, from 5.0% in December 2007 to 6.1% by August 2008.

All of which raises an obvious question: How or why was the Fed so surprised in September 2008, when the US financial system nearly collapsed? This was the month when Lehman Brothers famously went broke. But in the same month, Fannie Mae and Freddie Mac were placed into conservatorship, Bank of America bought out Merrill Lynch, the Fed authorized lending up to $85 billion to bail out the American International Group (AIG); the value of shares in the Reserve Primary Money Fund falls below $1, leading the Fed to announce a $50 billion program to guarantee investments in money market mutual funds;  Citigroup bought otherwise bankrupt Wachovia; and the Troubled Asset Relief Program (TARP) went to Congress, where it would be approved in early October. 

Stephen Golub, Ayse Kaya, Michael Reay offer some thoughts about \”What were they thinking? The Federal Reserve in the run-up to the 2008 financial crisis,\” in a short piece written for VoxEU, which is a condensation of a longer article by the same title forthcoming next year in the Review of International Political Economy, but already available online at the journal\’s website for those who have a personal or library subscription. 

The authors discuss in some detail what was being said at the meetings of the Federal Open Market Committee (FOMC), since the minutes of those meetings are now publicly available. In the discussion, they offer some simple counts of how many times certain terms came up. For example, here\’s a figure showing how often the terms \”inflation\” and \”growth\” came up at various FOMC meetings. Notice that in summer 2007,inflation is coming up quite a lot; indeed, there is some talk at several of the meetings that the Fed might need to raise interest rates soon to head off a surge of inflation–which of course turned out to be a gross misreading of where the economy was headed. 

Here\’s a figure showing how often and when the term \”subprime\” comes up. Notice a surge of mentions in 2007, as the problems in subprime markets first surfaced, but by summer 2008 the term was rarely coming up in these meetings. 

Or as another example, consider CDO and CDS, which stand for \”collateralized debt obligation,\” a kind of subprime mortgage-backed security that turned out to be especially risky, and \”credit default swap,\” a way of trying to insure against the risk of the CDOs. Again, talk of these in the Fed Open Market Committee meetings spiked in late 2007 and the very start of 2008, but had died down considerably by summer 2008.

The Fed was clearly aware of many of the issues about the housing price bubble in its deliberations–there are plenty of individual examples of the subject coming up in meetings and speeches. But in summer 2008, the Fed saw little need to focus on these issues or to take action. Of the many reasons that can be put forward for this seeming neglect of a looming crisis, Golub, Kaya, and Reay offer two that seem plausible to them. 

First, the Fed policymaking wascharacterized by a dominant paradigm, which we call ‘post hoc interventionism’. Post hoc interventionism held that bubbles were difficult to spot correctly, and that if a bubble developed, it could effectively be controlled after it had burst. Further, preventative pricking of bubbles could lead to an unnecessary economic contraction. Thus, monetary policy, instead of aiming at bubbles, should focus on flexible inflation targeting. Post hoc interventionism explains in part the Fed’s de-emphasis on financial stability in favor of inflation targeting. Second, we argue that the Fed’s institutional structure, conventions, and routines were crucial in maintaining post hoc interventionism as well as in undermining the impact of contrary events and dissenting opinions, as suggested by the literature on institutional pathologies in sociology and political science …

I largely agree with their argument, but I would add that I think the discussion at the Fed was influenced by the experience of the dot-com boom and crash that preceded the previous recession. There had been calls for years through the mid and late 1990s for the Fed to raise interest rates to limit the \”irrational exuberance\” of the dot-com boom, but the Fed (mostly) just let the boom continue, until it brought on the recession in 2001. That recession had been only six months long and not too deep. Thus, the thinking in summer 2008 was to expect a shallow recession, and to avoid bringing on a deeper recession.  Of course, this thinking neglected what later seemed an obvious point: the 2001 dot-com collapse was about stock market values, and while that pinched the economy, the 2007-2009 recession was about losses the value of debt owed to banks and other financial institutions, which posed a much more fundamental economic risk.

Golub, Kaya, and Reay also emphasize the Fed meetings tended to follow a certain format, where everyone around the table made a short presentation, typically just following up on the latest iterations of the information they had presented earlier. The meetings aimed for unanimity. The format of the meetings and the institutions wasn\’t set up to encourage challenges from critical ideas. Indeed, even certain groups  within the Fed like the Division of Banking Supervision and Regulation was typically not represented at these meetings, just because it wasn\’t part of the usual flow of information presented. The lesson here for all organizations is that if you keep looking in the same place all the time, you will inevitably miss the dangers that arise from any other direction.