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Thursday, August 4, 2011

A Nasty Graph

Here is an interesting graph from "Calculated Risk" I found on Jay Hancock's blog.


It vividly illustrates the critical difference between the employment picture emerging from the most recent recession compared to previous recessions.

The question is why the employment recovery has been so overwhelmingly anemic compared to the past and why the economy continues to struggle despite unprecedented policy actions both on the fiscal and monetary side.

The answer to me is clear.  The Federal Reserve caused the most recent recession by pushing interest rates down to 1% in the midst of a fairly robust housing market.  What people fail to grasp is that, by manipulating the federal funds rate, the Federal Open Market Committee (FOMC) is manipulating the most important price in the economy - the price of short-term money.  By driving the rate to 1% in 2003, they lowered sharply the price of housing (again, in a fairly robust housing market).  Then after sucking in fringe buyers with Fed-enabled teaser rates and exotic mortgages, they turned around and pushed rates sharply higher making the new mortgages unaffordable to new homeowners.

The part that people don't get, or better, don't want to see is that all of this has real effects in the labor market.  Instead of seeking an education that reflected the needs of the market, job seekers piled into the construction industry.  They piled into the mortgage broker industry.  They piled into fringe areas supporting these industries.  Great money could be made as a mortgage broker's assistant.  And so it went until the bust.

More recently, we have been in the mode of trying to figure out how to put the unemployed back to work and have slowly come to realize that this doesn't happen overnight.  The policy tools suggested by standard macroeconomic models aren't working.  The unemployed need new skills.  The ability to drive a nail is no longer in demand.

One question that needs examining is why the FOMC, under Greenspan and with the urging of Bernanke, pushed rates to 1% in 2003.  The line given is that they feared deflation lurking in the shadows.  But where is the evidence that deflation was imminent?  Macroeconomic forecasting is widely recognized as maybe just a half step above crystal ball grazing.

There was no deflation, and the disinflation that occurred certainly wasn't because of weakening demand.  It was because of the bust and the aftermath of the corporate governance problems with some lingering effects from 9/11.

At the time, there were accolades constantly showered on Greenspan.  Congress didn't understand his testimony but proclaimed his genius as he manipulated the fed funds rate during his tenure.  Too many accolades, especially in the macroeconomic policy arena, and soon arrogance begins to grow geometrically.  And that, IMHO, led us down the wrong path and to the results shown in the graph.


  1. Compared to Greenspan, I think Bernake is a saint! He is treated unfairly but he was handed down a rotten job.

    I sometimes feel bad for 'the Ben'!

  2. There are a lot more villains out there other than just Greenspan that contributed to the mess we find ourselves in, and most of them are around Washington (Frank, Dodd, Bush, Clinton, Rubin, Gramm) and the suburbs (Fannie, Freddie), and New York (AIG, GS, Bear, Lehman, Moodys, S&P, etc.).

    But the real question now is how do we get ourselves out of this mess. I'm not sure deficit spending and dollar debasement is going to do it. This time we just might have to take our medicine and get our financial house in order.

  3. re: MoneyCone We disagree on this one. Bernanke was instrumental in spreading the fear of deflation that led to the rate cut. I'm not a fan and believe he is given credit for slamming the brakes on a car that he was driving towards the cliff.
    re: A lot of people behaved badly. Still, I think we would have had a mild downturn but everything would be completely different today if short term rates were held at 3% or so where the market itself would have held them.
    The toxic mortgages that were packaged and badly rated and bought for off balance sheet accounts by banks would have never been created in the first place.
    If the government today pushed gasoline prices to $1/gallon to stimulate the economy a whole host of bad characters would arrive to exploit the situation. But they wouldn't be the cause.
    At least that's my take.