Although the recession has not yet been much deeper than its predecessors, it almost certainly will be by the time it is over. With banks still deleveraging and home prices still declining, consumer spending will remain under pressure for many months yet. Business investment is pulling back sharply: orders for capital goods sank 4% in October and commercial construction is about to feel the effects of the collapse in the market for commercial mortgage-backed securities. Exports will be pummelled by the global recession and the stronger dollar. Many economists expect the recession to continue until mid-2009, which would be longer than those of 1973-75 and 1981-82. Moreover, employment is likely to keep falling after the official end of the recession.
So if the Fed did not cause this and the past two recessions, what did? In his paper of a year ago, Mr Hall called them “mystery shocks”. Now, though, there’s less of a mystery; in both 2001 and now one sector experienced dramatic over-investment (technology then, housing now). The paradoxical truth may be that the less volatile business cycle (until recently) encouraged investors to take bigger risks with borrowed money, driving asset prices too high and ending in damaging busts. Some would still blame the Fed, for not deflating asset bubbles with higher interest rates. In a recent speech, Donald Kohn, the vice-chairman of the Fed, rejected that charge but pleaded guilty to a lesser one: by better controlling inflation, central banks helped moderate the business cycle, which bred investor complacency. They thus “may have accidentally contributed to the current crisis.” The Fed may no longer be the prime suspect for causing recessions; but it is still an accessory to the crime.
The Fed is the chief motivator of the business cycle. Artificially cheap credit and new high-powered money fuels irrational exuberance, which otherwise would hit a brick wall early on. The longer the Fed inflates the bubble, the worse the inevitable correction. There is no mystery to this.