In a thoughtful post Jim Hamilton summarizes the apparently current trend in the modeling of the financial crisis (emphasis added):
The objection that I have to many of these papers is that they focus too much on the effects of these disruptions and not enough on the causes. Many models take the view that credit markets were functioning more or less normally up until the fall of 2008, with the object of study taken to be understanding the consequences of how financial disruptions in 2008:Q4 were propagated to the rest of the economy.
... One of the papers from the conference on which I was asked to comment took the perspective that credit markets were functioning essentially normally in 2008:Q3, with the goal of the research being to quantify the consequences of the disruptions that occurred in 2008:Q4. But surely those disruptions had a great deal to do with the decline in house prices that had been underway for several years at that point, and just as surely that decline in house prices had a great deal to do with the run-up in house prices that preceded the bust.
... I presume that everyone would agree that the dislocations of 2008:Q4 did not arise in a vacuum. But some might nevertheless defend modeling those disruptions as exogenous events, if the primary purpose is to try to understand how those events affected the rest of the economy. However, I worry that this is more than just a detail of what one chooses to model, but has the danger of becoming a prevailing paradigm of some in policy circles, who may interpret the core problem as the financial events in the fall of 2008, rather than viewing the core problem as the conditions that precipitated those financial events.
Understanding those precipitating conditions strikes me as a higher priority for this kind of research. Is our goal to know how policy should respond to these disruptions, or how to prevent them in the first place? In terms of the narrow objective of evaluating Federal Reserve policy over this period, should we ignore the potential contribution of the low interest rates and lax regulatory regime that accompanied the preceding real-estate price run-up?
My suggestion for the many researchers interested in adding to our understanding of credit market imperfections would be to focus not so much on 2008 as on 2004-2006. Any economists or policy-makers who believe that the goal of policy is to restore the economy to the conditions of 2005 may be missing the core lesson here.
Perhaps the economists at the conference were just behaving rationally and following a fad or rather continuing a fad that is popular among DSGE and RBC-types where when all else fails just assume exogeneity. Or perhaps while a narrative is relatively easy, the details of putting them into a model are just too hard.
For instance, one such narrative is as follows:
But Taylor’s general contention that low rates after 2003 encouraged the housing bubble is largely persuasive, although mostly for different reasons than he provides. In June 2004 the Fed finally began raising the federal funds rate—the rate banks charge one another for overnight loans —as the recovery stabilized and employment and inflation began rising more rapidly. It probably should have started raising rates slightly earlier. Most important, the Fed raised rates only in increments of a quarter of a percentage point (twenty-five basis points); after seventeen such increases the federal funds rate peaked again in June 2006. Fourteen of these “measured” rate rises were attributable to Greenspan and three to Bernanke, who replaced him in February 2006.
Raising interest rates so slowly and steadily promoted excessive risk-taking, and should have concerned Greenspan, according to his stated views. The Fed’s policies thus seem especially peculiar. They helped to create a false sense of security and stability that enticed financial institutions and investors to leverage their investments enormously, borrowing sums that dwarfed the capital they committed.
... Getting the federal funds rate to near 3 percent much more quickly would have introduced a healthy dose of caution to investors in the years when the housing bubble inflated most rapidly. Moreover, the versions of the Taylor rule used by Federal Reserve policymakers not only suggest that rate increases should have started earlier in 2004, but also show that rates should have reached 3 percent before the end of that year.
How do we get at the counterfactual?