Published by EH.Net (December 2012)

Robert L. Hetzel, The Great Recession: Market Failure or Policy Failure? New York: Cambridge University Press, 2012. xii+ 384 pp. $50 (hardcover), ISBN: 978-1-107-01188-5.

Reviewed for EH.Net by Hugh Rockoff, Department of Economics, Rutgers University.

Two standard narratives about the causes of the crisis of 2008 have begun to take shape. A liberal narrative stresses the spread of a conservative free-market ideology, financial market deregulation, the subprime mortgage mania, and the inevitable bursting of the bubble. A conservative narrative stresses the low-interest policy of the Federal Reserve under Alan Greenspan, the decisions by Fannie Mae and Freddie Mac to finance subprime mortgages, and other mistaken government policies. The arguments are beginning to become predictable.

Robert Hetzel?s important new book offers a new interpretation. Hetzel does blame the Fed for turning an ordinary recession into the Great Recession.? But he does not blame the low-interest rate policy followed by Alan Greenspan?s Fed. Rather, Hetzel singles out the contractionary policy adopted by the Fed in the summer of 2008.

To understand Hetzel?s interpretation of 2008, it is helpful to begin with his equally novel interpretation of the Great Contraction and with Friedman and Schwartz?s interpretation in A Monetary History (1963), which is its starting place. Hetzel, although a student of Friedman, rejects important parts of the Friedman-and-Schwartz interpretation. In A Monetary History they argued that the banking panics of the 1930s, in some measure independent shocks, had put downward pressure on the money supply by encouraging the public to withdraw cash from banks and by encouraging banks to increase their holdings of cash. The Federal Reserve could have offset these trends, according to Friedman and Schwartz, by supplying additional reserves to the banking system through open market operations, but failed to so. The Fed committed some acts of commission in the late 1920s by tightening monetary policy in an attempt to stifle the boom on the stock market, but in their view its failures during the early 1930s were mostly acts of omission, including most importantly the failure to act as lender of last resort when a ?contagion of fear? enveloped the banking system.

Hetzel rejects this interpretation partly on the basis of the accumulation of studies since A Monetary History showing that the bank failures of the 1930s were usually due to insolvency (a product of the contraction in economic activity) rather than to illiquidity (caused by panic withdrawals from the banking system). Instead, the key mistakes for Hetzel were the decisions by the Federal Reserve district banks (they had the ability to set their own policies) to discourage borrowing by banks. The average rate of discount at most of the regional banks declined during the Great Contraction but remained above other short-term rates and thus discouraged bank borrowing. The New York Fed followed additional policies that essentially shut down borrowing altogether. It was a conscious if mistaken set of decisions to discourage bank borrowing that turned a recession into the Great Contraction.

While Hetzel?s conclusions are different from Friedman and Schwartz?s, his methodology, is similar. Hetzel believes in writing narrative history usually based on close readings of monthly data plotted on charts with the NBER recessions shaded in gray. Like Friedman and Schwartz, Hetzel believes in assembling data from a wide variety of sources, and carefully and respectfully analyzing the views of earlier writers. He writes, moreover, as they do, in plain English. I can remember encountering only one regression and a couple of equations.

Hetzel?s interpretation of the Great Recession of 2008 is similar to his interpretation of the Great Contraction: a mild economic downturn in 2007 ? produced by an energy price shock and the end of the real estate boom ? was turned into a severe contraction by bad monetary policy. The Fed?s big mistake, according to Hetzel, was the decision in the summer of 2008 to stop lowering the Federal Funds Rate, the rate at which banks lend short-term funds to each other, and the Fed?s operating target. The Fed, evidently, was worried about high headline inflation produced by the spike in energy prices. The Fed should have been looking, according to Hetzel, at the core rate of inflation. There are echoes here of statements by some Fed officials in the 1930s that an aggressive policy of open market purchases might augment reserves that would not be used during the depression but that would be used to support an increase in inflation or stock market speculation in the future.

The energy price spike has largely dropped out of discussions in the popular press of the Crisis of 2008, but there was a very substantial increase in the real price of crude oil in the years leading up to the crisis. Hamilton (2009) attributes the oil price shock mainly to surging demand and stagnant supply, and like Hetzel, believes that it contributed to the slowdown in the economy.

Hetzel?s key evidence for his interpretation is the timing of the deepening of the recession. In January through March of 2008 payroll employment declined 47,000 per month. In April through July payroll employment declined 207,000 per month. The declines were 267,000 in August and 434,000 in September, even before the failure of Lehman Brothers on September 15. This was the period in which the Fed kept the Federal Funds Rate steady. It remained at 2.0 percent from May to September. Thus, the crisis deepened, to put it simply, after the adoption of a contractionary monetary policy but before Lehman Brothers failed.

There were, of course, worrisome events in financial markets before the failure of Lehman Brothers triggered a classic panic. There were, to cite the most familiar examples, the takeover of Bear Stearns by JPMorgan Chase orchestrated by the Fed that played out between March and May of 2008 and the takeover of the troubled mortgage lender Countrywide Financial by Bank of America in July. But Hetzel amasses an impressive array of data to show that there was nothing unusual (for a downturn) happening in financial markets until the failure of Lehman Brothers. You can?t see much, for example, if you look at long-term interest rates. Still I must admit that I had some concern at this point in the argument. Perhaps fears about the future generated by these near failures, and by other bad news coming from the financial sector, may have had direct effects on consumption, investment, and production decisions that were not picked up by the standard indicators of financial market stress. After all, a contractionary monetary policy also did not produce an extraordinary reaction in financial markets.

Hetzel is a Senior Economist and Research Advisor in the Research Department of the Federal Reserve Bank of Richmond. It is therefore a tribute to Hetzel that he is willing to follow the truth where it leads. After all, what this book comes down to is that Hetzel believes that the big shots in the organization for which he works made big mistakes. Not everyone would be willing to say that, even if they believed it. And it is a tribute to the Fed, and perhaps to the unusual competitive structure of its research staffs, that it can tolerate dissent.?

In a brief review of this sort, it is not possible to deal with all the issues covered in Hetzel?s book. While the discussions of the causes of the Great Depression and the Great Recession are central, Hetzel also has interesting things to say on many other issues: the recovery from the Great Contraction, interwar international monetary experiments, postwar U.S. monetary policy, and the housing market in the period prior to 2008, among others. Chapter 8, ?From Stop-Go to the Great Moderation,? is an especially compelling discussion of postwar U.S. monetary policy.

Ben Bernanke in his classic paper on the Great Depression (1983) argued that the banking crisis in addition to putting downward pressure on the money supply had increased the cost of credit intermediation and destroyed many existing bank-borrower relationships, deepening and prolonging the depression. In the Crisis of 2008 Bernanke followed through on the implications of this analysis and devised a wide array of unconventional mechanisms to keep credit channels open. But in another important chapter, 14, Hetzel analyzes these policies in detail and concludes that they didn?t work. Old-fashioned monetary expansion, in Hetzel?s view, would have been better.

In the final chapters Hetzel explores some of the larger issues raised by his analysis including what is perhaps the biggest question of all: whether we can trust the price system to provide stable economic growth. The book is so wide ranging that my advice to any scholar taking up some new question about U.S. monetary history is that before you go very far in your research be sure to check to see if there is something of interest in The Great Recession.

I find Hetzel?s analysis of the Crisis of 2008 convincing. But one has to be realistic. Economic historians are still debating the causes of the Great Depression nearly 80 years after it began. Friedman and Schwartz?s interpretation, which remains central and controversial, is now 50 years old. Bernanke?s classic paper on the credit channel is 30 years old. Indeed, as I indicated above, Hetzel?s book offers a provocative new treatment of the early 1930s. Hopefully, we will begin to make more rapid progress. But the safest prediction would seem to be that in the year 2088 economic historians will still be debating the causes of the Crisis of 2008, and still citing and debating The Great Recession: Market Failure or Policy Failure?


Ben S. Bernanke, ?Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.? American Economic Review, Vol. 73, No. 3 (June 1983), pp. 257-276.

Milton Friedman and Anna J. Schwartz, A Monetary History of the United States, 1867-1960. Princeton: Princeton University Press, 1963.

James D. Hamilton, ?Causes and Consequences of the Oil Shock of 2007?08.? Brookings Papers on Economic Activity, Vol. 2009, (Spring 2009), pp. 215-261.

Hugh Rockoff is a professor of economics at Rutgers the State University of New Jersey and a research associate of the National Bureau of Economic Research. The views expressed here are his alone. His most recent publication is America?s Economic Way of War: War and the U.S. Economy from the Spanish-American War to the Persian Gulf War, New York: Cambridge University Press, 2012.

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