Macro myths
18 misconceptions about the Great Recession
I recently spoke to some Bentley University students (via zoom) about my views on the Great Recession. In this post, I summarize the substance of my talk. Long-time readers will have seen these arguments, but this blog has attracted some new readers who have asked me to justify contrarian claims such as, ”Tight money caused the Great Recession.” Here (in bold print) are 18 common misconceptions about the Great Recession:
There was a housing bubble that peaked in early 2006. The term ‘bubble’ often refers to excessive rates of new home building and/or irrationally inflated home prices. The US was not building too many homes in 2005-06; if we were you’d expect falling house prices, not rising prices. Indeed the inadequate level of home building during recent decades (due to the excesses of Nimbyism) is arguably the biggest economic problem in America. It is one of the most important reasons that living standards for the middle class have been rising more slowly than during the mid-20th century. In addition, there is no evidence that housing prices were irrationally high during the 2005-06 boom. If high housing prices caused the Great Recession, why didn’t the equally high (real) housing prices of 2022 cause a recession? The high housing prices of recent years are fully justified by the “fundamentals”.
The big drop in housing construction played a major role in the 2008 recession. This is factually inaccurate. The vast majority of the decline in home building occurred between January 2006 and April 2008, when residential construction declined by more than 50%. During that period of time, the unemployment rate barely budged, edging up from 4.7% to 5.0%. In a well functioning economy with adequate NGDP growth, a sharp decline on one sector, even a big sector, does not cause a recession. Other parts of the US economy continued to boom throughout 2006 and 2007. Unemployment only rose sharply after the spring of 2008, when tight money sharply reduced NGDP growth, leading to employment declines across a wide range of sectors.
The subprime mortgage fiasco largely explains the banking crisis. Most of the bank failures during the Great Recession occurred because of defaults on commercial loans, not subprime mortgages. This is exactly what you’d expect to occur when there is an unusually dramatic decline in NGDP growth. The banking crisis is not a puzzle that needs to be explained; the puzzle would be if an 8% drop in NGDP growth rates did not cause a banking crisis.
The banking crisis caused the Great Recession. The post-Lehman banking crisis occurred 9 months after the recession began, just as the banking crises of the 1930s occurred well after the Great Depression began. Again, banking crises are a symptom of falling NGDP, not a cause. Think of nominal GDP as the income that people and business have available to repay nominal debt.
A rapid economy recovery is not possible after a financial crisis. The fastest growth in industrial production in US history occurred in the spring and summer of 1933, despite much of the banking system being shut down. That’s because dollar devaluation led to rapid growth in NGDP. Monetary policy drives NGDP, and NGDP drives the business cycle in highly diversified economies like the US.
After the debt crisis, it was appropriate for aggregate demand to decline. Americans needed to “tighten their belts.” This conflates aggregate demand with consumption. When you’ve gone too far in debt, it makes sense to work harder, not take a long vacation. For a country, the response to too much debt should be more employment, more work effort, more production, not less. That’s how you “sacrifice”.
The Fed adopted an easy money policy in 2008. This is a textbook example of reasoning from a price change. Nominal interest rates did decline in 2008, but the natural interest rate declined even more rapidly. Other than short-term nominal interest rates, every other financial market indicator suggested that money got tighter over the course of 2008. Interest rates are not a good policy indicator.
Perhaps nominal rates are misleading, but surely the real interest rate is a good indicator of monetary policy. No, for the same reason that nominal rates are unreliable. Real interest rates also move around for a wide variety of reasons, not just monetary policy. In any case, real interest rates rose sharply throughout September, October, and November 2008, so if you believe real rates are the correct policy indicator, then you should agree with my claim that a tight money policy caused the Great Recession.
The Fed certainly did not cause the Great Recession, at most they did too little to avert it. The recession was triggered by falling velocity, not slower money growth. This is factually inaccurate. At the point where the economy first tipped into recession (December 2007), growth in the monetary base was slowing sharply, whereas base velocity was increasing. Between August 2007 and May 2008, the monetary base increased by only 0.2%, far below the previous trend of roughly 5%/year. Velocity actually increased over that 9-month period. To be clear, the base is not a reliable indicator of the stance of monetary policy (as it rose sharply in late 2008.) But the problem in late 2007 and early 2008 was more than simply errors of omission by the Fed. It was tight money.
The Fed did all it could to boost the economy in 2008; it simply ran out of ammunition. There are two problems with this claim. The Fed didn’t even cut its target interest rate to a level close to zero (actually 0.25%) until mid-December 2008, by which time most of the decline in NGDP had already occurred. In addition, the Fed has many tools that it can use after interest rates hit zero. Fiat money central banks never “run out of ammunition.”
The Fed did not intend its new program of interest on bank reserves to have a contractionary effect on the economy. Yes, it did. As Susan Woodward and Robert Hall pointed out, the Fed’s own explanation for the policy “amounts to a confession of the contractionary effect.” The Fed indicated that they implemented the policy to prevent interest rates from falling. The policy was enacted a few weeks after Lehman failed, when the global economy was plunging into a deep slump. An unforced error.
The zero lower bound problem held back the recovery during the early 2010s. When interest rates rose above the zero lower bound in late 2015, the economic recovery did not accelerate. This suggests that the sluggish growth in NGDP during the early 2010s was not caused by interest rates being stuck at zero.
Blaming the recession on falling NGDP is almost a tautology. If that were true, then poor countries could produce prosperity simply by printing lots of money, which would boost inflation, and thus NGDP growth. Does that seem likely to work? It’s true that in the US (but not Zimbabwe) there is a positive correlation between NGDP and real GDP, just as there is often a positive correlation between NGDP and other variables such as the money supply and interest rates. But any theory that NGDP causes changes in RGDP requires a plausible causal mechanism. In my view, that mechanism is sticky nominal wages.
The US caused the Great Recession, and Europe was hit by the ripple effects of the US crisis. The recession began at the same time in the Eurozone, and from the very beginning it was at least as bad in Europe. That’s because the hawkish ECB’s monetary policy was even more contractionary than Fed policy. If it were true that the US housing/banking crisis caused the recession, then it would have been much worse in the US.
The Eurozone debt crisis explains why Europe’s recession ended up being much worse than the US recession during the 2010s. Again, this confuses cause and effect. The ECB sharply tightened monetary policy in 2011, causing a double dip recession. That’s what triggered the eurozone debt crises (although irresponsible fiscal policies in places like Greece also played a role.)
The US policy of fiscal austerity slowed the recovery in 2013. This is what Keynesian economists like Paul Krugman predicted, indeed he suggested that 2013 would be a sort of test of the market monetary model. If so, we passed with flying colors, as GDP growth sped up after fiscal austerity began in January 2013. The Fed anticipated the fiscal tightening, and offset the effects with a more expansionary policy of monetary stimulus. Conversely, the tax rebates of the spring of 2008 failed to boost spending because the Fed offset them with tighter money.
High unemployment in the US during the 2010s was mostly due to “structural problems”. Contrary to the claims of many on the right, most of the unemployment was due to a shortfall in aggregate demand, and the unemployment rate fell back to a low level once wages fully adjusted. Don’t be a supply-sider or a demand-sider, be a supply and demand-sider.
More generous unemployment benefits led to increased aggregate demand, and this helped to boost employment. Contrary to the claims of many on the left, higher unemployment benefits do discourage work and lead to less employment. Don’t be a supply-sider or a demand-sider, be a supply and demand-sider. Keynesians predicted that employment growth would not accelerate after the extended unemployment benefit program lapsed in early 2014. They were wrong—employment growth did strongly accelerate in 2014.
In a recent post, I suggested that when people say, “The consensus view is X, but Y is actually true”, they intend their comment as a sort of prediction of future belief, a claim that, “Eventually, society will come to see Y as being true.” Think of this post as a prediction of the future consensus view. For instance, in late 2008 I complained that monetary policy was too tight. In his 2015 memoir, Ben Bernanke acknowledged that the Fed had erred in not cutting interest rates during the Fed meeting immediately after Lehman failed in September 2008.
Unfortunately, the vast majority of economists still believe most of these myths. If you’d like a more complete defense of my counterarguments, check out my book entitled The Money Illusion.
PS. Speaking of myths, here’s a detail from Titian’s The Andrians. Has anyone else captured the art of dance so perfectly?
From the Prado. Where else could it be?
PPS. Can someone please talk me back from the ledge? (Bucks fans will understand.)
A tight money policy by the Fed caused NGDP growth to plunge from its trend of roughly 5%/year to negative 3%. That 8% decline in NGDP growth made a deep recession almost inevitable.
I agree with some of your assertions but still think there were major flaws in lending in the American mortgage lending market. I wrote this earlier today in response to a liberal churning out standard tropes about 2008 and Bush.
Start of comment:
'The story of 2008 was never fully told. Why do you think nobody went to jail? The US government’s fingerprints were all over the crash.
In the early 1990s, the Department of Housing and Urban Development (HUD) implemented measures to increase homeownership among low- and moderate-income individuals. The Housing and Community Development Act of 1992 mandated that a certain percentage of Fannie Mae's and Freddie Mac's loan purchases be related to affordable housing. Initially set at 30%, these targets were progressively increased by HUD, reaching 56% by 2008. To meet these escalating goals, both GSEs committed substantial funds to purchasing loans from private lenders, including subprime mortgages. By 2008, they had pledged a combined total of $5 trillion toward such loans.
To fulfil affordable housing mandates, Fannie Mae and Freddie Mac increasingly acquired subprime and other high-risk mortgages. This strategy led to a significant accumulation of low-quality debt within their portfolios. By the time of the financial crisis, more than half of all mortgages in the United States were subprime or otherwise low-quality, with federal government agencies directly backing 76% of them.
I understand that the private sector banks and lenders also played a role in 2008. The role of CDS/CDOs cannot be understated in terms of hiding the problem and ratings agencies like Moody’s failed spectacularly. However, American government played a huge role in causing the global crash. Basically, they wanted to increase lending and homeownership amongst minority groups, hoping to atone for historical injustices of the kind found during the G.I. Bill an during the redlining period.
That’s a noble ambition, but any policy which is going to correct for such a huge problem cannot rely upon economic assumptions about bankers and politicians being smart enough to avoid boom and bust cycles for the first time in human history. Basically if one wants to reduce racial economic inequality one needs to look at the pipeline of education and consider solutions like vocational training- a quick look at Pew Research on income levels by race would tell one that using affordable housing provisions to try and solve racial housing inequalities was going to be doomed to failure. By definition, not having the income to repay a mortgage is a toxic bad debt.
I agree with you on Bush, but the problem originated under Clinton. Bush simply didn’t want to appear racist by cutting off funding for a program which made no sense from a lending risk perspective. Plus, I suspect he rather liked the artificial property and construction boom the bad lending was creating, and believed, like many, that the mortgage sector alone couldn’t crash the economy. That being said he was a complete coward on this issue, and is fully deserving of your scorn and derision.
What most people don’t realise is that finance is by far the strongest private sector lobby in the West, largely because of the relationship and leverage they enjoy with politicians and institutions. They accomplish politicians and institutional government's policy wonk political objectives and in return finance as a sector is given a wide latitude and little regulation. In America, banks aren’t even responsible for fraud committed against customers accounts, and financial advisors don’t even have a legal responsibility to advise in their clients best interests- yet SVB can get a bailout for large corporations whose investment strategy was criminally irresponsible. Janet Yellin made it clear under question no such consideration would be made for small community banks or regional banks.
The most recent mishmash of political and financial goals is ESG. It’s ticking timebomb because renewables simply aren’t profitable unless government engages in regulatory frameworks and price fixing which pushes the price of energy upwards- witness the failures of energy markets in the UK, Germany and California, the collapses of Sri Lanka and the energy rationing in South Africa. Of course, Sir Lanka and South Africa both had huge pre-existing problems, but the interjection of ESG is the proverbial tonne of straw which broke the camels back. McKinsey has since admitted that it faked reports which showed that increasing diversity improved company performance, and the larger players like BlackRock had long since divested themselves from ESG long before Trump won office.
Larry Fink may have assured the media that he was simply stopping using a weaponised term in the middle of 2023, but that’s not what he assured his investors or how BlackRock’s investment portfolio subsequently developed. Too many people were noticing that the ESG side of investments weren’t making money, and the portfolios were only propped up by asset speculation in the residential housing sector, and pricing strategies/debt-loading leveraged buyout mechanisms best left to disreputable private equity firms. When ESG does make money it's pure government-funded crony capitalism, paid for at the expense of the taxpayer.
Most people misassess the relationship between the finance sector and government. They imagine campaign finance and political donations are a primary factor. That’s chickenfeed by comparison to the genuine power of a true partnership between government and finance. Finance accomplishes governments absurd political goals of the moment, and in return finance is allowed to reign free and suffer little in the way of regulations to curtail the worst of their activities- and, of course, the other part of the relationship is that corporate bailout are always close to hand to cope with the added volatility and risk which stems from this relationship. As 2008 amply demonstrates, such relationships are inherently poisonous and have the potential to cause untold harm to societies writ large.'
End of comment.
My point would be this- American government policy created huge strategic risks in the American mortgage market. Your points are perfectly valid, but if the government intervention hadn't hopelessly loaded the mortgage market with toxic bad debt, the American market might have proved more resilient, or at least recovered far more quickly. I agree with you on the Europeans. Expansionary fiscal contractions has to be one of the most amusing policy lead balloons I've ever come across, if the results weren't so tragic.