The Great Recession didn\’t officially start until December 2007, but the warning signs came months earlier. Stephen G. Cecchetti explained in the Winter 2009 issue of the Journal of Economic Perspectives, in \”Crisis and Responses: The Federal Reserve in the Early Stages of the Financial Crisis.\”
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.
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.