In my recent Cato Institute policy analysis, "Requiem for QE," I analyze the transcripts of the 2008 and 2009 Federal Open Market Committee (FOMC) meetings in some detail. Among them, the March 2009 transcript stands out as particularly troubling, as it reveals the FOMC's failure to appreciate an economy's ability to heal itself through market mechanisms following an adverse macroeconomic shock.
Yet market economies do have self-correcting mechanisms: relative prices change, resources get reallocated, and consumer and business expectations adjust to new realities. In the case of the financial crisis, expectations had to adjust to the fact that house prices were significantly out of line with economic fundamentals. As they did, perceptions of wealth declined in line with house prices. Workers, particularly those in construction, began the process of acquiring new skills, finding alternative employment, starting new businesses, and so on. That these self-correction processes were already at work prior to the March 2009 FOMC meeting is one reason why the recession ended just three months later, in June 2009.
The same self-correcting mechanisms can be seen in the very markets in which the financial crisis began. Put simply, the financial crisis was precipitated by a decline in house prices which, in turn, sparked concerns about the default risk of banks and other financial institutions with large holdings of mortgage-backed securities (MBS).
The problem was that those holding the MBS had no knowledge of the specific real estate underlying the securities. As a result, once house prices crashed, and mortgage default rates spiked, no one could work out how much a given security was actually worth. MBS became "toxic assets" that couldn't be sold on the secondary market. In consequence, default risk spreads in interbank and other markets in which loans were made to institutions that held large quantities of MBS widened significantly in the early stages of the financial crisis, and subsequently exploded when Lehman made its bankruptcy announcement.
And yet even then, at the very height of the financial crisis, the market's self-correcting mechanisms were at work. Financial institutions had begun the process of discovering what specific real estate backed their MBS before Lehman's announcement, and the process accelerated thereafter. The success of these efforts is reflected in the fact that many default risk spreads had returned to their pre-Lehman levels (and in some cases to their pre-crisis levels) weeks before the March 2009 FOMC meeting.
Did the FOMC not see that financial markets and the economy had improved significantly by March 2009, or did it just have no confidence in the self-correcting nature of markets and market economies? The transcripts of the March meeting suggest the second answer.
Early in the discussion, President Plosser noted that he and President Bullard had recommended a change in the proposed policy statement. The proposed statement, which was distributed to participants prior to the meeting, read: "the Committee anticipates that policy actions to stabilize financial markets and institutions, together with fiscal and monetary stimulus, will contribute to a gradual resumption of sustainable economic growth." Plosser and Bullard proposed that the statement be amended to read: "the Committee anticipates that market forces and policy actions will contribute to a gradual resumption of sustainable economic growth." Plosser noted that the proposed statement implied that
policy actions alone will stabilize the world. And, frankly, I think creating an impression that the only game in town is policy actions and that market economies have no contribution to make in this stabilization is setting us up for failure and a credibility problem. So we added the reference to market forces.
One might suppose that Plosser and Bullard's recommendation generated considerable discussion and support, but one would be wrong. Not a single person responded; not Bernanke, not anyone. It was a Mr. Cellophane proposal — you'd never even know it was made.
Just before the policy vote was to be taken, Bernanke asked if there were any comments. Despite being summarily ignored, Plosser responded, "I had suggested this notion of putting in market forces in terms of returning to stability. I didn't know whether you had forgotten that, but nobody ever commented on it." Bernanke asked if people were okay with substituting the sentence. Governor Tarullo responded, "To what market forces are you referring?" Governor Kohn then added, "I think what I heard around the table, Mr. Chairman, was not much confidence that market forces are moving in that direction and might even be moving in the other direction."
"There's not much confidence that government forces are going to fix it either," Plosser replied. President Lacker interjected, "Surely, if the economy recovers, it's going to be a combination of policy actions and market forces. Surely that's the case." Bernanke responded, "Well, all we're saying here is that these things [policy actions] will contribute. We're not saying that they're the only reason. Let me go on." But President Bullard interrupted,
I just want to press on that a bit. It gives the impression that we're hanging on a thread as to what the Congress does or what we do or something like that. I don't think you want to leave that impression. Despite what the government does, you might recover faster or you might recover slower, and I think you should leave that thought in the minds of private citizens.
Bernanke replied, "Again, I think what we're saying here is that we anticipate that these things [policy actions] will contribute to an overall dynamic." Bernanke went on with the vote. The discussion was over.
The fact that only three of the 18 participants spoke out to suggest that the recovery would not be due solely to policy actions is disturbing. Bernanke's lack of support for the language is particularly worrisome because in his book, The Courage to Act, he notes that "as an economist, I instinctively trusted markets" (p. 99) and "I thought of myself as a Republican…with the standard economist's preference for relying on market forces where possible" (p. 108).
Curiously, he did not take a strong stand for "market forces," when he had the opportunity. He could have said, "our actions and fiscal policy are only assisting the market. We certainly don't want to leave the impression that policy will do it all." He could have said this when Plosser first made the recommendation or at any time during the discussion toward the end of the meeting. But he didn't. One is left to speculate why a person who instinctively trusts markets and market forces did not seize the opportunity to make a point about the role markets would play in mitigating the effects of the financial crisis and facilitating recovery.
The suggestion that market forces contribute to the improvement in the economy did not appear in the March 18, 2009, FOMC statement. Interestingly, however, the phrase "market forces" did appear in the April policy statement. But it received third billing: "the Committee continues to anticipate that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability" (italics added). The statement appeared in the draft language that was distributed to FOMC participants in advance of the meeting. There was no discussion of the role of market forces at the April meeting or any meeting in 2009. Was the statement included out of a deep-seated belief in the healing power of markets or merely to appease a small, but vocal, minority?
It is impossible to know for sure. But there is little doubt that the Committee failed to recognize that healing takes time. Monetary policy had already eased considerably by March 2009. The Fed's balance sheet more than doubled during the six months between September 18, 2008, and March 18, 2009 — increasing from $931.3 billion to $2 trillion. Instead of waiting and giving these actions, and the market's own healing power, time to work, the FOMC voted to expand the Fed's balance sheet by an additional $1.15 trillion.
This action paved the way for the FOMC's nearly 8-year zero interest rate policy, which has encouraged risk taking, redistributed income to the wealthy, contributed significantly to the rise in equity and house prices (which have surpassed their previous "bubble" levels), and created considerable uncertainty. If the FOMC had maintained some confidence in markets' ability to adapt, it would have waited a little longer to act and might have avoided an incredibly long-lived policy that will be extremely difficult to exit.