A Fed Economist Explains the Great Recession

Print/Save PDF

Until his retirement early this year, Robert Hetzel was Senior Economist and Research Advisor at the Federal Reserve Bank of Richmond. He was one of the surprisingly few Fed economists attempting to make comprehensive sense out of the Great Recession. In his 2012 book, The Great Recession: Market Failure or Policy Failure, he identifies the two fundamentally different approaches to understanding macro instability that have dominated the economic literature, market-disorder versus monetary-disorder modeling. Hetzel, an advocate of relying on the mainstream market-centric general-equilibrium theory in Fed policymaking, makes the case for the monetary-disorder paradigm. His analysis provides an instructive contrast to the GEM Project’s generalized-exchange theory that provides a demonstrably superior explanation of the evidence, mechanics, and management of acute instability. (Chapter 6)

Market-disorder view. From Hetzel (2012), p.2: “Adherents of the market-disorder view believe the sharp swings in expectations about the future from unfounded optimism to unfounded pessimism overwhelm the ability of offsetting changes in the real interest rate to stabilize economic activity. Those expectational swings arise independently of central bank actions and require discretion in the conduct of monetary policy. The failure of the price system to mitigate fluctuations in output provides an opening for the central bank and government to manage aggregate demand.”

Monetary-disorder view. “Adherents of the monetary-disorder view believe that the real interest rate works well as a flywheel to stabilize fluctuations in aggregate demand around potential produced by real demand shocks. However, money creation and destruction can interfere with [markets’] self-equilibrating powers. The conduct of monetary policy by a rule providing a nominal anchor and allowing market forces to determine the real interest rate and real output makes expectations into a stabilizing force by causing the public to anticipate that shocks that produce divergences between real aggregate demand and potential output will be short-lived.” (Hetzel (2012), p.2)

Generalized-exchange view. Two-venue modeling intuitively generalizes rational exchange from the marketplace to information-challenged workplaces. It degrades the dominating power of interest rates featured in single-venue (market-centric) thinking, helping to sweep away the case for monetary disorder as the principal cause of macro instability. Attention shifts to (i) the vulnerability of specialized economies to destructive meta-externalities rooted in the interaction of the continuous-equilibrium meaningful wage rigidity (MWR) and total-spending disturbances and (ii) the credibility of stabilization policymakers’ capacity to manage nominal demand sufficiently to effectively contain welfare loss. Milton Friedman’s assertion, emphasized by Hetzel, of the inherent stability of the private economy is inconsistent with generalized optimizing exchange organized by continuous general equilibrium as well as the evidence. It must be rejected in macroeconomics that aspires to be stabilization relevant.

Assessment. Hetzel is one of the many Fed economists who see the coherent market-centric dynamic-stochastic-general-equilibrium (DSGE) model class as a serious guide to stabilization policymaking. They believe that plausible nonmonetary disturbances are not propagated by total-spending disturbances interacting with MWR and do not push, absent policy mistakes, the economy outside the range of macro outcomes that are well-managed by the marketplace. Within that spontaneous corridor, the sole objective of discretionary monetary policy is low, stable inflation. Again from Hetzel: “… the monetary-disorder view is that the price system works well to equilibrate the economy, provided that monetary creation and destruction do not prevent the interest rate from adjusting. There is no inevitable movement from boom to bust. This view received empirical content from the hypothesis that to prevent the monetary emissions and absorptions that destabilize the price level, the central bank must follow a rule that provides for a stable nominal anchor and that allows market forces to determine the real interest rate and, by extension, other real variables.” Hetzel believes, not plausibly, that too-tight monetary policy caused the Great Recession.

The coherent generalized-exchange model class uniquely microfounds the causal link from nominal demand disturbances to involuntary job and income loss, considerably broadening the range of plausible causes of the 2008-09 acute instability and leading to conclusions far removed from Hetzel’s. The GEM Project understands that market failure is not unusual in continuous-equilibrium economies. As described by Modigliani (1977), such economies “need to be stabilized, can be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies.” Debate about the size of the spontaneous corridor turns on the existence and power of the microfounded MWR channel.

There is general agreement that the proper policy response to the Great Recession should include the identification and cost-effective correction of externalities implicated in the breakdown in the funding of globally interrelated financial institutions. Insightful analysts also understand that even optimally designed regulatory reform is much less important to stabilization policy than the effective management of aggregate nominal demand. That conclusion is supported by the fact that causes of financial crises are known to mutate in kind and place, partly as a result of efforts to avoid regulation. From the GEM Project perspective, the significant policy reforms would support more effective management of total-spending disturbances that propagate real financial shocks, producing instability that can generate self-referential confidence dynamics. Stabilization authorities must be provided more robust capacity (i) to intervene, quickly and in size, to halt and reverse contracting total demand and (ii) to manage associated investor/lender expectations about trend real-side macro prospects.

In a world that was long ago reorganized by the Second Industrial Revolution, motivating the monetary authority wholly by a low-inflation objective and relying wholly on interest rates is badly deficient. The central bank must also commit to real-side stability represented by full employment, with contingency plans that both effectively support that real-side objective and are persuasively communicated to global investors/lenders. A powerful message of generalized-exchange theory is that real-side credibility is the stabilization authorities’ most important deterrent to outsized welfare loss from financial crises.

Blog Type: Wonkish Chicago, Illinois

Write a Comment

Your email address will not be published.