The Great Recession of 2008-2009: Causes ... - Index of - IZA

Loose monetary policy versus global imbalances
Any post-mortem of the first decade of the 21st century cannot avoid the role that past US
administrations have played in shaping it. When faced with a recession in 2001 following the
bursting of the so-called ‘dot.com’ bubble, the US monetary authorities aggressively reduced
the policy interest rate to unprecedented levels and thus fuelled a debt-financed consumption
boom that led the way in boosting global aggregate demand. Interest rates in the US stood at
just 1 per cent in 2003 (Figure 3). This ensured that the 2001 recession was shallow and
short-lived, but it paradoxically sowed the seeds of the global recession of 2008-2009. 18 In
this respect, Taylor (2009) argues that over the period 2001-2006, the Federal Reserve’s
policy was too loose resulting in interest rates that were far lower than suggested by the
Taylor rule, which, in fact, was the largest deviation since the 1970s. 19 Indeed, the real
(inflation-corrected) funds rate was negative for 31 months (from October 2002 to April
2005).
In contrast, Elmendorf (2007) claims that interest rates were only ‘a little too easy for too
long, but the adjustments that appear optimal in hindsight would not have fundamentally
altered the housing cycle and related developments.’ (Elmendorf 2007: 3). In any case, by
focusing on a narrow definition of price stability, monetary policy in the US and elsewhere
failed to tackle the ballooning bubble in asset markets. At the same time, Shiller (2008)
points out that the housing boom in the US started in the late 1990s and thus predates the
period of excessively low interest rates, but acknowledges that loose monetary policy
contributed to the rapid growth in mortgages to sub-prime borrowers (see discussion below).
Looking at the long end of the market, yields on US government bonds (Treasury Bills) were
also unusually low during the pre-crisis period. 20 The low interest environment in the US
persisted because oil exporters in the Middle East and export powerhouses – led by China in
East Asia – developed a prodigious appetite for building up foreign exchange reserves in US
18
As argued by Reinhart and Rogoff (2009), the bursting of the dotcom bubble resulted in a relatively mild
recession because it had not been accompanied by an unsustainable increase in debt levels.
19
The Taylor rule prescribes how a central bank should adjust its interest rate policy instrument in response to
changes in inflation and macroeconomic activity. In particular, the rule implies that the real short-term interest
rate should be determined according to three factors: (1) where actual inflation is relative to the targeted level;
(2) how far economic activity is above or below its full employment level; and (3) what the level of the shortterm
interest rate is that would be consistent with full employment. See, for example, Orphanides (2007).
20
See US Treasury data, http://www.ustreas.gov/tic/ticsec2.shtml
15