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What Frontline Missed: The Counterfactual of Fed Intervention

PBS Frontline released a documentary Tuesday, The Power of the Fed, and it has everyone talking—and not just those who work in finance. Many friends and colleagues have reached out to me for my interpretation of the program, so I thought I would write a quick post about what I think about it. Let me first say that I encourage all of The Demand Side readers to watch the program because PBS is great, and the special is very informative and easily digestible for those less familiar with the inner workings of modern central banks. Having said this, the program wasn't without bias.

James Jacoby, Frontline’s producer and interviewer in this documentary, takes viewers on a largely one-sided tour of the actions the Federal Reserve took during the financial crisis of 2008 and the Covid-19 pandemic. He sits down with some of the most prominent financial players and leading economic thinkers to discuss these actions and their ramifications, which is constructive no doubt. The criticism I have with the special is not that it wasn't well researched or that it didn't have reputable expert commentary—because it certainly was, and it did—but that PBS didn't look very hard at what would have happened had the Fed not acted in the manner it did over the past 12 years.

The story’s premise—that the Fed embarked on a journey into uncharted waters by engaging in multiple rounds of quantitative easing and setting up ad hoc facilities to deal with Covid-19 economic fallout, both of which only resulted in more wealth inequality, the creation of multiple asset bubbles, and incentivized moral hazard on Wall Street—is a myopic way of looking at what took place during those crises. Their view, while appealing to viewers and I'm confident great for PBS’s ratings, it isn't the whole story for a couple of reasons.

First, it is without objection that lower interest rates have caused asset prices to increase of the last decade, most notably home prices and stock prices. No reasonable economist would challenge that dynamic or challenge the fact that the majority of individuals who own stocks are those at the top of the income spectrum, making them the biggest winners in a low interest rate environment. But there is much more that happens when interest rates are low. Over the last decade, low interest rates have allowed many individuals to borrow for their first home rather than continue renting; they have let business owners restructure problematic debts and plan for the future; and they have allowed families to begin building real wealth or at least put them on more sound financial footing so that they can one day start building wealth.

The second reason Frontline's narrative is misleading is that it failed to dig into what former Dallas Fed President Richard Fisher talked about at the beginning of the documentary. In describing 2008, he said, "What the Federal Reserve does is provide the blood supply for the body of our capitalist economy. And what happened in 2008 is that all the veins and the capillaries and the arteries collapsed. So, every financial function had failed—it had collapsed—and we had to restore them." In my opinion, this is an apt metaphor for what happened during the financial crisis: individuals, companies, and families were all deleveraging (selling assets, calling in loans, saving their money) during the fall of 2008, and while those actions are prudent when faced with economic hardship, when everyone does this at the same, it becomes a serious macroeconomic problem, and that problem manifests with a widespread lack of credit available to those who need it. The blood (i.e., credit) was not pumping. The veins, capillaries, and arteries (i.e., the banking system) collapsed, and the only way to fix this was to pump credit back into the banking system, which is exactly what the Fed did. They lowered rates through open market operations by buying assets from banks and giving them capital to lend out. There is nothing unusual or suspect about those actions; it is precisely what was called for. In fact, many economists (including myself) would say the Fed didn't do enough because they didn't take interest rates into negative territory.

The problem, or at least what Frontline sees as the problem, came once the Fed hit the zero lower-bound; that is, when the Fed Funds rate hit zero and they couldn‘t lower interest rates any further. (Note: As previously stated, the Fed could have taken the policy rate into negative territory, but the FOMC felt more comfortable using QE rather than negative rates, which is understandable given the political environment they faced)

At the zero lower-bound (ZLB) the only thing the Fed can do from an interest rate standpoint is to purchase Treasury bonds, mortgage-backed securities, and other long-duration securities to bring down long-term interest rates. This is where Frontline focuses their story. The rise in asset prices as a result of the Fed's open market operations spread throughout all asset classes, and only those who participate in these markets—mainly, the wealthy—benefited from their appreciation.

But the reality is that because the Fed took short-term rates to zero and pulled down long-term rates, the Fed created very favorable borrowing conditions which helped stop the bleeding. Also, by backstopping the mortgage market the Fed prevented mortgage rates from skyrocketing, and by supporting various lending facilities set up by the US Treasury, many bankruptcies and job losses were avoided.

All of these actions were more than responsible at the time. What Frontline failed to recognize is what would have happened had these actions not been taken—essentially, what's the economic counterfactual of the Fed's actions? Yes, the Fed has contributed to elevating asset prices over the last few years. Yes, its Covid-19 response has made the Fed a major player in markets it typically has little involvement in. And yes, the Fed has created new lending facilities to support the American economy in an unprecedented fashion. But what would have happened had the Fed not done these things? Does Frontline honestly think we would be better off today if the Fed had sat on its hands?

I could go into the details of the various models that simulate the 2008 counterfactual on lost GDP, unemployment, and inflation had the Fed not acted—and the same analysis for the Covid-19 crisis—but you can just google those articles. There are plenty. The key point here is that, in both circumstances, without Fed action, we were mere days away from another Great Depression. And if Frontline thinks that outcome is preferable, all so wealth inequality doesn't get worse, then, Frontline, you are drastically misinformed. As Minneapolis Fed President Neel Kashkari said when interviewed by Frontline, "The Fed has been on a mission, I have been on a mission, to put Americans back to work and help them get their wages up, especially for those lowest income Americans. And if it has had some effect on Wall Street, to me the tradeoff is well worth it if we can put Americans back to work so that they can put food on the table—that they can take care of themselves. That is profoundly beneficial to society."


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