Monetary disorder – not animal spirits – caused the Great Recession

If one follows the financial media on a daily basis as I do there is ample room to get both depressed and frustrated over the coverage of the financial markets. Often market movements are described as being very irrational and the description of what is happening in the markets is often based on an “understanding” of economic agents as somebody who have huge mood swings due to what Keynes termed animal spirits.

Swings in the financial markets created by these animal spirits then apparently impact the macroeconomy through the impact on investment and private consumption. In this understanding markets move up and down based on rather irrational mood swings among investors. This is what Robert Hetzel has called the “market disorder”-view. It is market imperfections and particularly the animal spirits of investors which created swings not only in the markets, but also in the financial markets. Bob obviously in his new book convincingly demonstrates that this “theory” is grossly flawed and that animal spirits is not the cause of neither the volatility in the markets nor did animal spirits cause the present crisis.

The Great Recession is a result of numerous monetary policy mistakes – this is the “monetary disorder”-view – rather than a result of irrational investors behaving as drunken fools. This is very easy to illustrate. Just have a look first at S&P500 during the Great Recession.

The 6-7 phases of the Great Recession – so far

We can basically spot six or seven overall phases in S&P500 since the onset of the crisis. In my view all of these phases or shifts in “market sentiment” can easy be shown to coincide with monetary policy changes from either the Federal Reserve or the ECB (or to some extent also the PBoC).

We can start out with the very unfortunate decision by the ECB to hike interest rates in July 2008. Shortly after the ECB hike the S&P500 plummeted (and yes, yes Lehman Brother collapses in the process). The free fall in S&P500 was to some extent curbed by relatively steep interest rate reductions in the Autumn of 2008 from all of the major central banks in the world. However, the drop in the US stock markets did not come to an end before March 2009.

March-April 2009: TAF and dollar swap lines

However, from March-April 2009 the US stock markets recovered strongly and the recovery continued all through 2009. So what happened in March-April 2009? Did all investors suddenly out of the blue become optimists? Nope. From early March the Federal Reserve stepped up its efforts to improve its role as lender-of-last resort. The de facto collapse of the Fed primary dealer system in the Autumn of 2008 had effective made it very hard for the Fed to function as a lender-of-last-resort and effectively the Fed could not provide sufficient dollar liquidity to the market. See more on this topic in George Selgin’s excellent paper  “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

Here especially the two things are important. First, the so-called Term Auction Facility (TAF). TAF was first introduced in 2007, but was expanded considerably on March 9 2009. This is also the day the S&P500 bottomed out! That is certainly no coincidence.

Second, on April 9 when the Fed announced that it had opened dollar swap lines with a number of central banks around the world. Both measures significantly reduced the lack of dollar liquidity. As a result the supply of dollars effectively was increased sharply relatively to the demand for dollars. This effectively ended the first monetary contraction during the early stage of the Great Recession and the results are very visible in S&P500.

This as it very clear from the graph above the Fed’s effects to increase the supply of dollar liquidity in March-April 2009 completely coincides with the beginning of the up-leg in the S&P500. It was not animal spirits that triggered the recovery in S&P500, but rather easier monetary conditions.

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

The dollar swap lines expired February 1 2010. That could hardly be a surprise to the markets, but nonetheless this seem to have coincided with the S&P500 beginning to loose steam in the early part of 2010. However, it was probably more important that speculation grew in the markets that global central banks could move to tighten monetary conditions in respond to the continued recovery in the global economy at that time.

On January 12 2010 the People’s Bank of China increased reserve requirements for the Chinese banks. In the following months the PBoC moved to tighten monetary conditions further. Other central banks also started to signal future monetary tightening.

Even the Federal Reserve signaled that it might be reversing it’s monetary stance. Hence, on February 18 2010 the Fed increased the discount rate by 25bp. The Fed insisted that it was not monetary tightening, but judging from the market reaction it could hardly be seen by investors as anything else.

Overall the impression investors most have got from the actions from PBoC, the Fed and other central banks in early 2010 was that the central banks now was moving closer to initiating monetary tightening. Not surprisingly this coincides with the S&P500 starting to move sideways in the first half of 2010. This also coincides with the “Greek crisis” becoming a market theme for the first time.

August 27 2010: Ben Bernanke announces QE2 and stock market takes off again

By mid-2010 it had become very clear that talk of monetary tightening had bene premature and the Federal Reserve started to signal that a new round of monetary easing might be forthcoming and on August 27 at his now famous Jackson Hole speech Ben Bernanke basically announced a new round quantitative easing – the so-called QE2. The actual policy was not implemented before November, but as any Market Monetarist would tell you – it is the Chuck Norris effect of monetary policy: Monetary policy mainly works through expectations.

The quasi-announcement of QE2 on August 27 is pretty closely connected with another up-leg in S&P500 starting in August 2010. The actual upturn in the market, however, started slightly before Bernanke’s speech. This is probably a reflection that the markets started to anticipate that Bernanke was inching closer to introducing QE2. See for example this news article from early August 2010. This obviously is an example of Scott Sumner’s point that monetary policy works with long and variable leads. Hence, monetary policy might be working before it is actually announced if the market start to price in the action beforehand.

April and July 2011: The ECB’s catastrophic rate hikes

The upturn in the S&P500 lasted the reminder of 2010 and continued into 2011, but commodity prices also inched up and when two major negative supply shocks (revolutions in Northern Africa and the Japanese Tsunami) hit in early 2011 headline inflation increased in the euro zone. This triggered the ECB to take the near catastrophic decision to increase interest rates twice – once in April and then again in July. At the same time the ECB also started to scale back liquidity programs.

The market movements in the S&P500 to a very large extent coincide with the ECB’s rate hikes. The ECB hiked the first time on April 7. Shortly there after – on April 29 – the S&P500 reached it’s 2011 peak. The ECB hiked for the second time on July 7 and even signaled more rate hikes! Shortly thereafter S&P500 slumped. This obviously also coincided with the “euro crisis” flaring up once again.

September-December 2011: “Low for longer”, Operation twist and LTRO – cleaning up your own mess

The re-escalation of the European crisis got the Federal Reserve into action. On September 9 2011 the FOMC announced that it would keep interest rates low at least until 2013. Not exactly a policy that is in the spirit of Market Monetarism, but nonetheless a signal that the Fed acknowledged the need for monetary easing. Interestingly enough September 9 2011 was also the date where the three-month centered moving average of S&P500 bottomed out.

On September 21 2011 the Federal Reserve launched what has come to be known as Operation Twist. Once again this is certainly not a kind of monetary operation which is loved by Market Monetarists, but again at least it was an signal that the Fed acknowledged the need for monetary easing.

The Fed’s actions in September pretty much coincided with S&P500 starting a new up-leg. The recovery in S&P500 got further imputes after the ECB finally acknowledged a responsibility for cleaning up the mess after the two rate hikes earlier in 2011 and on December 8 the ECB introduced the so-called 3-year longer-term refinancing operations (LTRO).

The rally in S&P500 hence got more momentum after the introduction of the 3-year LTRO in December 2011 and the rally lasted until March-April 2012.

The present downturn: Have a look at ECB’s new collateral rules

We are presently in the midst of a new crisis and the media attention is on the Greek political situation and while the need for monetary policy easing in the euro zone finally seem to be moving up on the agenda there is still very little acknowledgement in the general debate about the monetary causes of this crisis. But again we can explain the last downturn in S&P500 by looking at monetary policy.

On March 23 the ECB moved to tighten the rules for banks’ use of assets as collateral. This basically coincided with the S&P500 reaching its peak for the year so far on March 19 and in the period that has followed numerous European central bankers have ruled out that there is a need for monetary easing (who are they kidding?)

Conclusion: its monetary disorder and not animal spirits

Above I have tried to show that the major ups and downs in the US stock markets since 2008 can be explained by changes monetary policy by the major central banks in the world. Hence, the volatility in the markets is a direct consequence of monetary policy failure rather than irrational investor behavior. Therefore, the best way to ensure stability in the financial markets is to ensure nominal stability through a rule based monetary policy. It is time for central banks to do some soul searching rather than blaming animal spirits.

This in no way is a full account of the causes of the Great Recession, but rather meant to show that changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years. I have used the S&P500 to illustrate this, but a similar picture would emerge if the story was told with US or German bond yields, inflation expectations, commodity prices or exchange rates.

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

March-April 2009: Fed expand TAF and introduces dollar swap lines

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

September-December 2011: Fed announces policy to keep rate very low until the end of 2013 and introduces “operation twist”. The ECB introduces the 3-year LTRO

March 2012: ECB tightens collateral rules

Leave a comment


  1. I agree wholeheartedly. The rather obcessive behavior regarding inflation that has become pervasive in our central banks is quite harmful in itself because their job isn’t so much about economic technicalities as it is about managing market expectations. So if they become overly protective of their inflation targets and forecasts, ignoring market realities, they can’t get out in front of any praticular crisis, which only makes the crisis bigger as damage happens and contagion becomes a reality almost with no end. It doesn’t really matter what the targets are or how well they are being met if markets do not trust that the CB’s will get out in front of issues so they don’t needlessly become larger. A bit more inflation is cheap comared to the real losses from contagion and lost opportunity because of lack of trust and the fear factor.

  2. Bill Woolsey

     /  May 25, 2012

    In my view, the only way a change in “animal spirits” could impact spending on output is if it someone leads to an excess demand for money. And an excess demand for money is always the fault of the central bank, whose duty is to adjust the quantity of money to the demand to hold it. Of course, it is a difficult responsibility, because the demand for money isn’t directly observable, but by committing to return nominal GDP to a target growth path, it can always come close enough to avoid anything like a Great Recession.

    Stable growth in nominal expenditure does’t require that businessman on average have stable expectations. If we were on a gold standard, and the demand for gold was inversely related to “animal spirits,” then there would be a difficulty. Efforts to avoid sharp changes in interest rates or to stabilize some measure of the quantity of money has similar effects as a gold standard.

    But it isn’t necessary.

  3. Lars, 2008 october 13 swap line decisions were much more important than 2009 april swap line decisions.

  4. 123, judging from the market reaction – what happened in March-April was “enough” to turn around expectations. The actions in October 2008 didn’t do the job. It might be that it would have been even worse it the swap lines had not been introduced in October 2008, but my point is that ALL of the major turns in the US stock markets over the past fours can be explained by changes in monetary policy.

  5. W. Peden

     /  May 26, 2012

    Great post.

    With the precipitous drop in September 2008, could one add that Congress granted the fed the power to pay interest on excess reserves? So suddenly it becomes rational to expect a ceteris paribus rise the value of base money vs. stocks, bonds, loans etc.

    One thing that’s fascinating about this graph is that the decline in stock prices took place almost entirely before central bank rates in the US, UK and (I imagine) the ECB hit zero. Even for the most devoted believer in the liquidity trap, there was still plenty that monetary policy could have been doing in 2008. For those of us who see 0% central bank rates as political rather than economical constraints, this means that even the easy actions weren’t being taken while they were justified.

  6. Alex Salter

     /  May 26, 2012

    I think we should take care when we use the phrase “Great Recession.” I agree that the failure of the Fed to satisfy skyrocketing money demand was the proximate cause of the downturn being as nasty as it was (and continues to be, perhaps?). However, there would still have been a market correction resulting from the bursting of the real estate bubble. We should make sure we distinguish this correction from the “secondary deflation” which put the Great in Great Recession. This is exactly the same point Milton Friedman made in his work on the Great Depression.

  7. Diego Espinosa

     /  May 27, 2012


    “changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years”

    The S&P500 has doubled in three years compared to four in 1933-1937. If the S&P500 is the metric of policy effectiveness, then Bernanke has FDR beat hands down.

  8. Diego,

    I think it is pretty clear that we are in a crisis which is much smaller in scope than in 1930s.

    That said, I sat out to demonstrate that market movements primarily is a reflection of monetary policy rather than animal spirits. I think I have demonstrated that pretty clearly.

    Furthermore, as I note the S&P500 is just one of many markets one could look at. European stocks have seen the same kind of market action. However, European stocks have traded sideways for the last three years. This is probably a pretty good illustration of the difference in monetary policy in the euro zone and the US. One could of course also have a look at bond yields or exchange rates.

    • Diego Espinosa

       /  May 27, 2012

      A thought experiment. Imagine MM’s were around in 1933, and were arguing for abandonment of the gold standard. Imagine also that you traveled from the future and described the situation in March 2009 and the Fed’s policy reaction. Would those 1933 MM’s predict a bigger stock market move from the gold market exit than from Bernanke’s “Credit Easing+Inflation Targeting” policy?

      • Diego, that is an interesting thought experiment.

        I think the answer most say that the US monetary policies after 1933 was far from perfect. And the 1937-recession clearly shows that the US Treasury and the Fed had very clear problems about what they were targeting. In that sense the post-1933 period and the last four years are similar. In both case the Fed finally move to do something about undoing the tightening of monetary policy, but it was (and is today) within a highly discretionary regime. That was a problem in the 1930s – as it is today.

  9. Diego Espinosa

     /  May 27, 2012

    MM’s generally argue that FDR had a much bigger impact on expectations than Bernanke. Its worth noting that market prices do not necessarily support this thesis.

    Its interesting to think about why something so substandard as Bernanke’s policy could produce a better market reaction than FDR’s gold exit. One thesis is that both moves were primarily directed at increasing business investment through higher profit expectations that drove higher asset prices. The Bernanke move quickly restored corporate profits-to-gdp to peak levels — an astounding recovery. The employment recovery, unfortunately, did not follow the same path. Could it be that profits impact worked in similar ways in ’33 and ’09, but, for structural reasons, the employment outcome differed?

    BTW, expected overseas profit growth does not account for the difference. Even the NIPA (domestic) profit recovery has been back to peak levels. Further, the domestic-heavy Russell 2000 has outperformed the S&P500.

    • Diego,

      Once again thanks for your comments. They are very relevant and interesting. In fact these are issues that have been on my mind for some time – especially the recovery in NIPA profits.

      I am not sure that market monetarists in general is giving higher marks to FDR than to Bernanke. But of course the decision to leave the gold standard is seen as hugely important. That said, I am certainly no big fan of FDR’s economic policies. NIRA for example was a disaster and US Treasury played a huge role in the 1937-recession in my view.

      Anyway, your make a valid point. A study comparing the two “events” could clearly be interesting.

      • Diego,

        I must admit I have not been paying a lot of attention to the relative performance of the US stock market during the 1930s and now. However, your point is obviously right that the S&P500 is doing a lot better today than was the case from 1933 to 1936/37. It just came to my mind that at least the Obama administration has not been doing as much damage as FDR did when it comes to regulation. As I note NIRA was horrific. In that comparison Obamacare is really nothing. That might explain the performance in stock prices then and now. But that might actually be worth a blog post own its own. Or in fact it might be worth an entire book. Scott Sumner of course has an unpublished manuscript on the Great Depression in which he discusses the massively negative consequences of NIRA. I hope somebody soon will publish that book…

  10. Diego,

    I now have had a look at the numbers. I think they give an somewhat different picture than the one you paint.

    The recovery in Dow Jones from the bottom in early 1933 (February) and a year ahead was extremely impressive. Dow Jones rose more than 90% from the bottom. The recovery in Dow Jones was much weaker in 2009. Over 12 month Dow Jones was less than 50%. Hence, what FDR did in 1933 had a much more powerful impact on the US stock market than Bernanke did in 2009.

    And the FDR “outperformance” continues during the four following years. However, it is correct the Dow Jones is basically flat in 1934 and into 1935. That in my view is probably the NIRA effect.

    Anyway, I have done this fast – it would need more thinking, but I think it is pretty hard to say that Bernanke has been more positive for the US stock market than FDR are was (including the horrors of NIRA!).

  11. flow5

     /  May 28, 2012

    The various policy responses were subordinate to the actual unrecognized driver – monetary flows (our means-of-payment money Xs its transactions rate-of-turnover). Simply because most of the FED’s interdictions were ill-timed, the financial market’s reactions were decisive.

    Contrary to economic theory, & Nobel laureate Dr. Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically (always), fixed in length (mathematical constants).
    For example, as soon as Bernanke was appointed to the Chairman of the Federal Reserve, he initiated a “contractionary” money policy for 29 consecutive months, (coinciding both with the end of the housing bubble, & the peak in the Case-Shiller’s National Housing Index in the 2nd qtr of 2006 @ 189.93), or at first, sufficient to wring inflation out of the economy, but persisting until the economy plunged into a depression.

    A “contractionary” money policy (decelerating roc’s in nominal gDp prior to the Great Recession), is defined as one where the rate-of-change (roc) in monetary flows is less than 2% above the rate-of-change in the real output of goods & services. I.e., MVt’s roc’s were NEGATIVE (less than zero), for 29 consecutive months.

    The FOMC continued to drain liquidity despite its 7 reductions in the FFR (which began on 9/18/07). I.e., despite Bear Sterns two hedge funds that collapsed on July 16, 2007, & immediately thereafter filed for bankruptcy protection on July 31, 2007, the FED maintained its “tight” money policy [i.e., credit easing (mix of assets), not quantitative easing (injecting reserves)].

    Nominal gDp’s 2 year roc peaked in the 2nd qtr of 2006 @ 12%. Bernanke let it fall to 8% by the 4th qtr of 2007 (or by 33%). It fell to 6% in the 3rd qtr of 2008 (another 25%). It then plummeted to a -2% in the 2nd qtr of 2009 (another [gasp] – 133%).

    I.e., Bernanke didn’t initiate an “easy” money policy until Lehman Brothers later filed for bankruptcy protection (& it was one the Federal Reserve Bank of New York’s primary dealers in the Treasury Market), on September 15, 2008. The next day AIG’s stock dropped 60%.

    The freefall in gDp during the 4th qtr of 2008 was disguised early on because the Commerce Department reported retail sales increased by 1.2% over October 2006, & up a huge 6.3% from November 2006. However (in Dec 2007), the roc in MVt projected a peak in the proxy for real-output during July – followed by NEGATIVE roc’s (less than zero) in Oct, Nov, & Dec of 2008.

  12. Diego Espinosa

     /  May 28, 2012

    You are right. I was measuring the effect from the Gold Reserve Act, which was 1934. The appropriate date is probably April of 1933, when FDR forbid private ownership (thus telegraphing the end of the standard). The market actually tripled from that level.

    One thing I would say, however: the Russell 2000 is probably less manufacturing-heavy than the Dow of 1933, which reflects our services-dominant (and less monetary policy-elastic) economy. If we were to compare apples to apples, its possible the recovery of stock prices has been similar.

    In any case, thanks for setting the record straight on the Dow.

  13. Lars, Ambrose Evans-Pritchard continues to give excellent commentary on the Eurozone follies, keeping the ECB in his sights:

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