Jim Young / Reuters U.S. Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke leave a ceremony to debut the new design for the $100 note at the Department of the Treasury in Washington, April 2010.  

The Fed and the Great Recession

How Better Monetary Policy Can Avert the Next Crisis

Today, there is essentially one accepted narrative of the economic crisis that began in late 2007. Overly optimistic homebuyers and reckless lenders in the United States created a housing price bubble. Regulators were asleep at the switch. When the bubble inevitably popped, the government had to bail out the banks, and the United States suffered its deepest and longest slump since the 1930s. For anyone who has seen or read The Big Short, this story will be familiar.

Yet it is also wrong. The real cause of the Great Recession lay not in the housing market but in the misguided monetary policy of the Federal Reserve. As the economy began to collapse in 2008, the Fed focused on solving the housing crisis. Yet the housing crisis was a distraction. On its own, it might have caused a weak recession, but little more. As the Fed bailed out the banks at risk from innumerable bad mortgages, it ignored the root cause of serious recessions: a fall in nominal GDP, or NGDP, which counts the total value of all goods and services produced in the United States, not adjusted for inflation. Such a fall began unimpeded in mid-2008, and once that happened, much of the damage had been done.

The Fed can control NGDP through its monetary policy, and as NGDP fell in 2008, the Fed should have lowered interest rates rapidly. If that proved insufficient, it should have increased the money supply through quantitative easing. Instead, the Fed, terrified of inflation, kept interest rates too high for too long—causing NGDP to fall even further.

To prevent such errors in the future, the Fed should switch from targeting inflation to targeting the level of NGDP. When a recession hits, NGDP tends to fall before inflation, which means that a central bank focused on targeting inflation will be too slow to respond. Throughout mid-2008, U.S. inflation remained positive, as NGDP began falling. Had the Fed targeted NGDP, it might have acted much sooner to boost

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