Would The U.S. Economy Have Double Dipped If The Fed Raised Rates in 2003?

The Chris Whalen interview on CNBC has me thinking about the Federal Reserve’s policy dilemma right now. If you haven’t seen his comments on interest rates, read my post Roubini, Bremmer and Whalen: Fixing the Financial System and Double Dipping and watch the clip.

Now I agree with Chris that low rates are poison. My last point points to why. But, here’s how I put the train of events during the housing bubble in The Dummy’s Guide to the US Banking Crisis:

  1. In 2001, following a massive stock market and capital spending bubble, Federal Reserve Chairman Alan Greenspan worried that the U.S. faced a severe recession. He began cutting interest rates down to 1% and kept them at that level until 2004, raising them slowly only 0.25% at a time thereafter.
  2. With interest rates so low, the financial services industry sensed a lot of money could be made and went all in on real estate, seemingly unaware that low interest rates were masking large risks.
  3. Meanwhile, Americans had been anticipating a nasty downturn after the bubble burst. But, they soon realized that money lost in the stock market was more than offset by rising home prices. So, Americans continued to spend freely.
  4. As Americans spent freely, the U.S. went further into debt with the rest of the world. Foreigners, used their dollar IOUs from these debts to start their own bubbles too.
  5. Eventually, things started to unravel in 2006 when those that could least afford to purchase homes — so called subprime borrowers — started to default in the U.S., prices having run well out of their range of affordability.

We all know that the easy money led to the housing bubble, just as it had done in the 1990s with the technology bubble. Doesn’t it seem like we are on that very same path right now? Yes, I know the downturn is more severe, but on the whole, it is the same turn of events: severe shock and lingering unemployment met with low interest rates and fiscal stimulus.

Now go back to early last decade after the technology bubble popped. Stocks were amazingly weak and didn’t bottom until autumn 2002. Unemployment peaked in June 2003!  That’s 19 months after the recession ended. We were in a world of hurt. People forget. I guarantee you Americans would not have spent so freely if rates were higher.

Here’s how David Leonhardt of the New York Times covered the story in June 2003 when unemployment was peaking:

Trying to bring the long economic downturn to a halt at last, the Federal Reserve cut short-term interest rates by a quarter of a point today, taking them to their lowest level since 1958.

To the disappointment of the stock and bond markets, the Fed rejected a half-point cut and explained in a statement that the economy appeared to be improving but could still benefit from easier credit.

”Recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing,” the Fed’s statement read. ”The economy, nonetheless, has yet to exhibit sustainable growth.”

In a sign of how radically the Fed has changed its focus over the last three years, officials also said that concerns about price declines, rather than inflation, were ”likely to predominate for the foreseeable future.” The statement, economists said, signaled that the Fed, while still viewing the risk of deflation as minor, planned to keep interest rates low for an extended period.

Alan Greenspan defends himself and the ultra-low rates by saying in effect we surely would have double dipped and deflation would have stepped in had he not gone for the easy money. Is Sir Alan right?

Yes or No?

I’ll leave it at that and let you comment. We’ll run this poll out a few days and see what people say.

Source: Federal Reserve Lowers Key Rate To 1%, Lowest Level Since 1958, David Leonhardt, NYTimes

  1. Kirk Kinder says

    The US may have lingered in recession longer (or it would have been deeper) in 2001 had rates not been dropped, but we would have cleaned the excesses from the system. Not only did Greenspan kick the can down the road, but when we finally reached the can again it had grown due to low rates. Debt levels rose substantially.

    Even with rates as low as they are now, the consumer and corporations seem to continue on the deleveraging path. Just look at consumer credit; it is dropping like a rock.

    So my poll vote was for a double dip, but I think it would have been the healthier option.

  2. Scott Harrison says

    This survey is ambiguous for the reason because you have not qualified the question with “if Greesnpan had raised rates above the neutral rate”. That shows all my biases and reveals a contradiction because as a free marketeer, I assume the neutral rate does not really exist, or at least that we could not know if we were above or below it at the time.

    As an opinion, if we had double dipped in 2004 or 2005 with the lag (another bias, I assume the Austrian viewpoint where resctrictive monetary policy has a negative effect on economic growth), would that have been such a bad thing? I was unemployed at the time and got my first job out of college right around 2003 so maybe it would have been, but I was younger and more resillant than I am now (and in a hell of a lot less debt). It may not have been that bad.

  3. Traderscrucible says

    We’ve been in something like a recession since 2001. Much of our lost generation has already happened.

    The fed policy response was correct given that we’re not in an MMT guided world.

    It is also important to know that Greenspan was knowingly creating a real estate frenzy. If you look at his statements, you’ll see that he was quite clear about using the U.S. housing market as an economic prop.

  4. Edward Harrison says

    Sorry that the comments here just showed up. All comments got caught up in some sort of spam filter. Warren Mosler has been telling me that there is no evidence of a connection between rates and GDP growth. I believe there is. At a minimum, however, asset prices respond to low rates via the inclination to increase leverage as rates are lowered. Given the evidence that asset prices and medium-term growth are related, I tend to think that lower rates lead to a boost in growth. Like some other commenters here I think the short/medium term hit is worth it because of the distortionary effects of the Fed’s policies.

    1. Scott says

      Hey Ed:

      I voted and gave a human point of view to throw some support behind your site.

      I have an econ opinion request. We’ve been through hell and back. Two years ago today it was all about the paradox of thrift. Two years later it’s all about accounting identities and sectoral balances. How did we advance from basic Keynsianism to sectoral balances? If I read Paul McCully right he’s still in the land of Minskey and Keynes. He did not change. He’s still hanging on. It may be only because of the focus of your site, but all libetarian arguments aside, in your opinion, was their a real coup in theory in the last two years or are we still playing the same old games?

      I’m an old schooler. I think Adam Smith still plays. I think Marx still plays. I think Keynes still plays. I think Hume still plays. I prefer the old schoolers because I can read them and learn more from learning what was the same 200 years ago and compare that to my existence today than I can from what is apparently new today. I’m going to continue to be a neophyte until someone explains how life has changed in the mean time and why we need new theories. We made it this far. Why do we need all this new theory? Life has not changed that much. Same old s— different day. It’s all about who controls the spoils like it always has been. No theory changes that.

      Back to my point, do you think the sectoral balances model has changed life? and do you think this model is a significant change in economic thought? (I’ve only noticed it over the past year, but that does not make it significant. I think I’ll ride the classics and experience ’till the end. That’s a safer bet unless you can say this is revolutionary. Most propenents only say that it is an identity. So what? doesn’t help my starving daughter any (single, no kids))

      Great site,


  5. Attitude_Check says

    We would have doubled dipped – we needed to due to the malinvestment of the tech bubble. Instead Greenspan blew a bigger bubble with even MORE malinvestment, requiring EVEN GREATER recession/depression to fix.

    Of course the FRAUD in the system has only magnified the boom, and the necessary bust.

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