The 1991 US recession and recovery illustrate in several ways the relevance of the issues upon which we have focused. We want to argue that the recession, though from some perspectives shallow and short, could have been even shorter and shallower, if the Fed had correctly understood the role and behavior of financial institutions – and banks in particular. This is, of course, a remarkable criticism, since, if the Fed is an expert on anything, it surely is on the nature of the US financial system. But the Fed relied on (implicitly or explicitly) over–simplistic models, including modern developments of the standard IS–LM curves, which did not adequately take into account the nature of financial markets. As a result, the Fed was taken by surprise at the inefficacy of its policies.

The recovery itself represents somewhat a puzzle. The standard mantra put forward, not only by the Clinton Administration, which wished to claim credit for it, but also by the popular press, was that the deficit reduction allowed the Fed to lower interest rates, and this provided the needed stimulation of the economy. But this explanation, while widely accepted both within the economics profession and by pundits more generally, was deeply disturbing.