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.
"I agree with you on Bush, but the problem originated under Clinton."
Your comment is way too long, and I have no idea what you mean by agreeing with me on Bush. I did not blame Bush for anything. I don't deny that the government foolishly encouraged subprime loans, but that's not the topic of my post. I am discussing what caused the recession, not what caused the banking problems.
I should have put much of the comment in quotation marks. I wasn't clear. I had made the comment earlier in the day in response to a Leftist arguing against reducing federal government. He had reeled out the trope about Bush and the private sector causing 2008. I apologise for being unclear. I just thought you might find the comment interesting.
Subprime loans are an easy target because they were incomprehensible - who would loan money to a person without verification of income? How many of these "liar loans" were really issued? I have no idea. I do believe that during periods of credit exuberance, dishonest actors have a skill at taking advantage of the lack of oversight - meaning I do believe the mortgage mania of the early 2000s invited a lot of fraud (similar fraud has been documented as part of the Covid PPP loans).
I believe the heart of the loan story is that Wall Street misrepresented the value of its financial products. Goldman Sachs executives didn't want to go to jail. So the financiers spun stories to blame the stupid American consumer and the loan originators. But it was the Wall Street firms who concocted the idea that mixing bad debt with good debt would make all the debt good. They were wrong and they made the entire country pay for their greedy mistake.
I'd add that as late as August 2008, the Fed could have avoided a recession if it loosened significantly. The drop in RGDP to that point would have been less than a normal recession if they didn't keep the brakes on.
"...Ten years later, however, came what proved in retrospect to be the pivotal event. The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord’s risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Thus, where a well-capitalized commercial bank needed to devote $10 of capital to $100 worth of commercial loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to spend only $2 of capital on a mortgage-backed security (MBS) worth $100. A bank interested in reducing its capital cushion — also known as 'leveraging up' — would gain a 60 percent benefit from trading its mortgages for MBSs and an 80 percent benefit for trading its commercial loans and corporate securities for MBSs. Astute readers will smell a connection between the Recourse Rule and the financial crisis. By 2008 approximately 81 percent of all the rated MBSs held by American commercial banks were rated AAA, and 93 percent of all the MBSs that the banks held were either triple‑A rated or were issued by a GSE, thus complying with the Recourse Rule..."
Our system of bank regulation has been a fiasco almost since the country was founded. The underlying problem today is that moral hazard (FDIC) causes banks to take excessive risks. But that's not what caused the Great Recession.
Unless one thinks anyone should get a loan no matter if they have the ability to repay it or not, at least in regard to real estate loans for single family home owners, money was not too tight preceding the great recession.
Anyone could get "liar loans" with balloons and a lot of people did, Many compounded their debt with "equity" loans based not just on actual equity, but projected equity increases. Consumers were sold on these loans with fantasy projections of unending growth. Being "too big to fail" the lenders had incentive to gamble on making loans for short term gain.
If causing growth in a market by applying unrealistic criteria for expending credit is not creating a bubble what is it?
Two points. 1. I do not believe that money was too tight before the recession, I think it was too tight during the recession.
2. Tight money has nothing to do with tight credit. Don't conflate money and credit, two radically different concepts. You measure the stance of money by looking at NGDP growth---when it's too slow, then money is tight.
The Fed had been countering credit-funded demand by tightening the growth of currency, which kept NGDP growth stable before 2008. The subprime boom rose up in late 2003 and collapsed entirely by mid-2007. Then, in 2008, well after all that had happened, the federal mortgage agencies greatly tightened mortgage access at a much larger scale than the subprime boom had loosened it so that suddenly mortgage access was much tighter than it had been for decades. When they did that, the Fed did nothing to counter it, and the crisis in late 2008, the collapse in construction employment after that, and the slow recovery afterward were the result.
'The subprime boom rose up in late 2003 and collapsed entirely by mid-2007. Then, in 2008, well after all that had happened, the federal mortgage agencies greatly tightened mortgage access at a much larger scale than the subprime boom had loosened it so that suddenly mortgage access was much tighter than it had been for decades. When they did that, the Fed did nothing to counter it, and the crisis in late 2008, the collapse in construction employment after that, and the slow recovery afterward were the result.'
I didn't know they tried tightening. The must have finally woken up to the Sword of Damocles their affordable housing provisions had created. See my other comment on the subject.
Also, I would say your other comment begs the question. None of those programs were important factors in creating either a housing boom or the recession.
Unfortunately, for decades, urban land use restrictions have been making housing more expensive, and the economists, analysts, and politicians who should be the most vocal advocates for fixing it spent decades building up a false counternarrative focused on federal programs, lending, and interest rates. Two decades after 2008, 1/3 of the former mortgage market has been eliminated by federal regulators, and interest rates have risen substantially, but those old mistaken explanations are hard to let go of.
I see you've beaten me to it! I agree, but would argue that most of the constraints are imposed by political economics- government regulatory frameworks. I would argue that there is a distinct difference between affordable homes (bad) and housing affordability (good). Demand stoking government programs don't help the issue, because the residential housing sector doesn't fit the efficient market hypothesis.
Most people don't realise that as scarcity costs for building land increase, profit margins for actually building houses shrink- all the profits go to land development and husbanding land through an increasingly complex and burdensome government regulatory framework. In the UK, this particular market has become incredibly bifurcated. Many CEOs of Housing Associations (traditionally charities, or enjoying mutual status) now earn very impressive executive compensation, because of the money they make for private equity firms through land development. I'm not criticising them for that- merely the government created conditions that make it possible.
There is plenty of suitable land for building in the UK. The exclusion zone in London is filled with concrete covered wastelands of no environmental importance, with ready access to roads. But it's an Iron Triangle of Interest- and the last thing the Upper and Upper Middle Class people of Henley want is White Van Man moving into their area, his children invading their children's schools. America is somewhat different. There is huge potential to develop an entire generation of American starter homes. It would solve the population crisis. It would probably boost entrepreneurship, by changing the debt calculation of the younger generation. The only thing necessary is for government to reform itself, especially at the local level.
Pigs will probably learn to fly first.
One thing worth checking out is Swedish housing. Their private sector has done some really good work on making cheap great liveable prefabricated homes. About 50% of the work is now carried out off-site.
I would argue that today, on net, the government acts as a suppressor of mortgage access and that mortgage access is much more of a supply stoking factor than a demand stoking factor. Millions of new starter homes in lightly regulated smaller cities have not been built since 2008 because of the mortgage crackdown. The main effect of pre-2008 federal mortgage agencies was to lower rents because of their effect on single family housing supply.
Not really. I attribute about 8% home price appreciation from 2002-2006 to changing credit conditions. A blip. The rest was supply. The credit blip had reversed by 2008. Then the 2008 tightening caused aggregate home values in the US to drop by something like 20-25%.
Re housing bubble: I've calculated new housing completions relative to population growth for the 2000s. Look at these while recalling average household size around 2.5, which implies 40 additional houses for every 100 new residents.
Cities with stagnant populations where rents are stable appear to typically build about 3 units per 1,000 existing residents to maintain stock because of depreciation and replacement needs. When you factor that in, the 2000s was a very moderate building boom. Much more moderate than the building booms of the mid-20th century.
Cochrane believes that if the public looses confidence that the government will adequately service the debt, they will plan that the government will inflate away the difference.
And he has a role for the monetary policy in his model.
I don't see that ngdp targeting is inconsistent with his model. But I'm not familiar enough with the model to completely assess.
But, of course you make a most compelling case about ngdp and the recession.
Yes, he has more of a fiscal theory of the price level. I disagree. I think monetary policy drives inflation, and fiscal policy is not really much of a factor in the US.
Nice post. Question from an ignoramus about #13. Why are wages sticky, and why is that stickiness the "glue" that attaches NGDP to RGDP? Is it wage-earners' susceptibility to the illusion that money has inherent value? Without which, wage earners would accept a pay cut as long as a price-level cut would occur that's at least as large?
Actually, Wall Street is even "stickier" than workers, as nominal debt contracts (bonds) often last far longer than wage contracts. Prices are also sticky. So I take stickiness as a given.
I use the "musical chairs model" as a metaphor for how stickiness causes nominal shocks to have real effects. NGDP is the total revenue that firms have available to pay workers. If NGDP falls unexpectedly, and nominal hourly wages are unchanged, then the number of hours worked will usually fall. Profits may also fall, but at least some of the burden will be absorbed by workers. The historical data very strongly confirms this claim.
Yes, Scott, what is actually sticky are the prices Wall Street pays for long duration assets. Money managers, including corporate planners, want price stability. And price stability is desirable.
Incomes & wages are not nearly as sticky as claimed or imagined. American businesses typically handle labor costs to match the business cycle of that business. For example, construction businesses have incredible wage flexibility and they hire and fire workers immediately, as well as add or reduce hours. Construction as with other cyclical businesses also rely on bonuses and the amount of bonus varies year by year.
There is a mountain of empirical support for sticky wages. It doesn't have to be true that all wages are sticky in order for wage stickiness to be a big problem. Your anecdotes are meaningless, no bearing on my claim.
Thanks, that makes sense. If we include mortgages and car notes as nominal debt contracts too, that explains why workers are sticky (though not as sticky as Wall Street)?
In 2008 the Federal Reserve felt constrained in bailing out failing financial firms. They allowed Lehman to fail and Wall Street threw a temper tantrum. So Wall Street got a bailout even though main street banks said they didn't need one.
In 2023 the Federal Reserve along with the Treasury offered unlimited intervention to prevent bank failures. US equities have soared and the economy has seemingly recovered from the 2022 post COVID stimulus lows.
However, by conventional accounting the Federal Reset is insolvent. Google AI explains: "Yes, the Federal Reserve is technically insolvent, meaning its liabilities exceed its assets. However, the Fed is able to continue operating because it can create money to cover its losses."
Privatizing gains, socializing losses. And that is exactly what we see playing out in the American economy! The agenda seems to be to never allow distressed selling. Prices must be stable and otherwise rise. To our overlords, stock prices and home prices are the economy!
This plan sounds perfect! Except how much market intervention is required? How much economic distortion does it create?
I basically agree with this, but it's a different topic from my post. My post discusses the cause of the 2008 recession, not problems with the financial system. The two issues seem related, but are actually mostly unrelated.
I think we want monetary management to have separation from economic activity but the nature of credit creates a dependency. When credit is emitted in anticipation of economic gains, who holds the bag if what is anticipated does not come to pass?
The Federal Reserve appears to have embraced the idea that if it can prevent credit crisis then it can achieve monetary stability. Does it not occur to anyone that this "guarantee" invites ever greater speculation and ever greater credit expansion?
It is observed knowledge that a way to mitigate massive forest fires is to have more frequent, smaller fires. The Federal Reserve has opted to avoid any clearing of dead assets - lest there be a credit crisis. Thus, when the next credit crisis hits it will be much larger and much more damaging.
I wish I could believe otherwise but I don't believe a risk free world exists - yet the Federal Reserve surely believes it can cover all financial risk and prevent anyone from getting hurt from collapsing credit, even when the credit goes bad because it was based on a serious blunder and miscalculation.
By the way, in 2008 the fastest way to recovery would have been to let assets and debt be repriced lower. Let the imprudent fail and let the wise profit from that failure. Instead we ended up with QE and a decade of subsidized interest rates, as well as overregulation of the credit markets (Kevin Erdmann is correct about this) that have yielded a massive distortion in the economy. But in response to Kevin, if the Fed is going to guarantee debt, then don't be surprised if the politicians heavily regulate who deserves it!
I am trying to reconcile 14 and 9. It is easy to imagine both the fed and ecb making the same errors of omission at the same time as a failure to respond to some global change. What errors of commission would they have made at the same time and what might have been the root cause of them both doing that?
I only recall hearing talk of central bank coordination after the troubles began. Have they always been doing this?
Central bank mistakes are correlated, but not perfectly correlated. (For instance, China did not have high inflation post-Covid.) The policy mistakes are somewhat correlated because they all tend to operate with the same flawed interest rate targeting approach. If you are targeting interest rates, and the natural interest rate declines without the central bank noticing, then policy can easily become more contractionary than the central bank intended.
Okay, it sounds like you are saying the error of commission was letting M growth fall as the interest stayed fixed. Its easier to just agree the policy framework is flawed then dissect the difference between omission and comission
I recently re-read The Money Illusion and I appreciate this summary of some of your main claims. The book has a lot of detail on your ideas of how the crisis happened and lots of accompanying data, but I found that much of the story is discussed in depth across few different chapters; having the pieces in one place is useful.
One thing I still don't understand about your model though is where the tight monetary policy came from in the first place. If the causation is X -> tight money -> recession -> subprime loan/banking crisis, what is X? I'm sure this is in your book somewhere but I must have missed it.
See reply to Andrew above. In addition to the natural interest rate problem, you also had a big commodity price spike in 2008 (due to China's boom) which led central banks to become overly concerned with inflation, at a time when they should have been focusing on slowing NGDP growth.
BTW, I really appreciate your willingness to reread the book. These sorts of books require a lot of work, and earn very little in royalties. So I am gratified any time someone takes the time to read the book.
Here's a thought. Write down a model in the language of science, which is mathematics. That model will have equations. Those equations will have parameters. Those parameters are constants. If they are constants that can be measure, then measure them.
I am confident that no such model can be or ever has been written down. Why? Because macroeconomics is a collection of epiphenomenon and because there are no constants in human behavior.
NGDP is the sum of millions of Ps x Qs added up (I could write that out mathematically just about anywhere else using standard mathematical notions, but not in a comment on Substack). If most of the Ps are going up and most of the Qs are not, or might even be falling, what's the secret sauce of juicing the Ps by creating additional money? No hand waving allowed. Write down a model. Then we can all examine it.
We can predict the long running statistical distribution of dice rolls just fine, we don't need to have a model of air resistance, bouncing off the table or physiology of the human hand.
Yes, we would need all these details to predict how any one die roll plays out. But it's pretty irrelevant for the statistical distribution. That distribution is a collection of epiphenomena.
Your original assertion that economics is hard (or even impossible) to properly model might still be correct, I don't know. After all, it's easy to come up with invalid arguments even for correct assertions.
I didn't say economics; I said macroeconomics. Rolling dice and probability distributions that arise from it are completely deterministic, not by some magic, but by the simple concept of relative frequency. Air resistance isn't involved in the least, nor is the physiology of a hand. There is no analogy with aggregates of Ps and Qs and dice.
I wrote a book explaining my model. You are free to examine it if you wish. You are also free to ignore it. But don't waste time trying to convince me of your narrow-minded theories of epistemology. The dogs bark, the caravan . . .
Kind of what I expected you would say, instead of addressing the important point about no constants to be measured. Keep looking for the lost ring under the street light, right? Where's the caravan going? So far as I can see over the past 50 years, no where.
Incidentally, I'm not trying to convince you of anything. Just putting out an idea that you didn't respond to, for whatever reason.
Please address bank leverage as a possible contributor in so far as banks originated, packaged and securitized any number of loans, particular mortgage loans that were not on their balance sheets and ability to do so may have had to do with too much leverage in the banking system.
Had Greenspan at the time said to bank heads to sell off loans or raise equity is it not possible that this might have lessened the GFC if not avoided it in its entirety?
Across the globe banking institutions and others were seeking the highest risk adjusted instruments and banks in say Scandinavia bought any number of securitized bond and tranches of these instruments, and inter bank lending was also large.
I see the banking industry as a culprit and much related to securitized loans. thanks.
"Please address bank leverage as a possible contributor"
Contributor to what? If this post were on the financial crisis, I'd certainly discuss excessive bank leverage. But it's not. The post is on the Great Recession, which is a different issue from the financial crisis. That's why I ignored bank leverage. I'm trying to explain what caused the Great Recession, not consider symptoms of the Great Recession.
If total nominal spending in the economy (= ngdp) is help stable, a reshuffle of the banking system one way or another doesn't cause a recession.
Leverage isn't special. Banks (and every other company) have to finance their balance sheet somehow. They typically use a combination of debt and equity, but there's nothing magic about either option.
Btw, common wisdom has is that the problem with too much leverage is that the eventual deleveraging. You suggested 'solution' would force that very problem, not avoid it.
As Scott says in his post, companies and customers service loans out of their nominal income (= ngdp). As long as that's held stable, they can in aggregate service their loans.
Awesome, this is very useful. Will definitely be sharing this.
> Real interest rates also move around for a wide variety of reasons, not just monetary policy.
There are related problems in the study of dynamic systems where a variable has an important relationship with a process, but is also influenced by things outside of that process in a way that sometimes confuses observers about the causal relationships. For example, your motor behavior is caused by neuromotor signals, but is also influenced by gravity and mechanical forces outside of your brain's control. The same mistakes economists have made are mirrored elsewhere, I think.
PS, Bucks will be fine, just need to follow Mavs and trade Giannis to the Knicks for KAT and a first.
Both tax increases and spending cuts. This reduced the deficit from about $1050 billion in 2012 to about $560 billion in 2013. Note that I use calendar data, not the more widely available "fiscal year data". That's because the austerity started January 1st, 2013.
Yes. I don't deny there were ripple effects from our banking problems in Europe, but initially it was widely expected that the recession would be much milder in Europe, because people wrongly thought that financial turmoil was causing the recession. Actually, it was tight money. If the actual problem was financial stress, then the recession would have been far worse in America.
I guess this where I’m getting stuck: why would rescission have been much worse in US if Euro banks also had significant exposure to the very same issues affecting US banks?
It's a question of degree. Yes, European banks had some exposure to the US market, but nowhere near the exposure of US banks. European banks tend to focus on Europe, and US banks tend to focus on the US. Again, I'm not denying some ripple effects, but you'd certainly expect the primary hit to have been to the US banks.
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.
"I agree with you on Bush, but the problem originated under Clinton."
Your comment is way too long, and I have no idea what you mean by agreeing with me on Bush. I did not blame Bush for anything. I don't deny that the government foolishly encouraged subprime loans, but that's not the topic of my post. I am discussing what caused the recession, not what caused the banking problems.
I should have put much of the comment in quotation marks. I wasn't clear. I had made the comment earlier in the day in response to a Leftist arguing against reducing federal government. He had reeled out the trope about Bush and the private sector causing 2008. I apologise for being unclear. I just thought you might find the comment interesting.
Thanks for clarifying.
Kevin Erdmann is the guy to read about mortgage loans during that time, subprime or otherwise.
From what I remember, he didn't see much of a problem with subprime loans.
(Encouraging them might still be foolish, I don't know how much of that actually happened. But it wasn't much of a problem in any case.)
Subprime loans are an easy target because they were incomprehensible - who would loan money to a person without verification of income? How many of these "liar loans" were really issued? I have no idea. I do believe that during periods of credit exuberance, dishonest actors have a skill at taking advantage of the lack of oversight - meaning I do believe the mortgage mania of the early 2000s invited a lot of fraud (similar fraud has been documented as part of the Covid PPP loans).
I believe the heart of the loan story is that Wall Street misrepresented the value of its financial products. Goldman Sachs executives didn't want to go to jail. So the financiers spun stories to blame the stupid American consumer and the loan originators. But it was the Wall Street firms who concocted the idea that mixing bad debt with good debt would make all the debt good. They were wrong and they made the entire country pay for their greedy mistake.
"They were wrong and they made the entire country pay for their greedy mistake."
Not really. The federal government made the country pay. GS shareholders paid for GS mistakes.
I'd add that as late as August 2008, the Fed could have avoided a recession if it loosened significantly. The drop in RGDP to that point would have been less than a normal recession if they didn't keep the brakes on.
That's correct.
I doubt that. The money multiplier was significantly degraded by that time.
Scott- thoughts on this Cato piece?
https://www.cato.org/policy-report/january/february-2010/perfect-storm-ignorance
"...Ten years later, however, came what proved in retrospect to be the pivotal event. The FDIC, the Fed, the Comptroller of the Currency, and the Office of Thrift Supervision issued an amendment to Basel I, the Recourse Rule, that extended the accord’s risk differentiations to asset-backed securities (ABS): bonds backed by credit card debt, or car loans — or mortgages — required a mere 2 percent capital cushion, as long as these bonds were rated AA or AAA or were issued by a government-sponsored enterprise (GSE), such as Fannie or Freddie. Thus, where a well-capitalized commercial bank needed to devote $10 of capital to $100 worth of commercial loans or corporate bonds, or $5 to $100 worth of mortgages, it needed to spend only $2 of capital on a mortgage-backed security (MBS) worth $100. A bank interested in reducing its capital cushion — also known as 'leveraging up' — would gain a 60 percent benefit from trading its mortgages for MBSs and an 80 percent benefit for trading its commercial loans and corporate securities for MBSs. Astute readers will smell a connection between the Recourse Rule and the financial crisis. By 2008 approximately 81 percent of all the rated MBSs held by American commercial banks were rated AAA, and 93 percent of all the MBSs that the banks held were either triple‑A rated or were issued by a GSE, thus complying with the Recourse Rule..."
Our system of bank regulation has been a fiasco almost since the country was founded. The underlying problem today is that moral hazard (FDIC) causes banks to take excessive risks. But that's not what caused the Great Recession.
Unless one thinks anyone should get a loan no matter if they have the ability to repay it or not, at least in regard to real estate loans for single family home owners, money was not too tight preceding the great recession.
Anyone could get "liar loans" with balloons and a lot of people did, Many compounded their debt with "equity" loans based not just on actual equity, but projected equity increases. Consumers were sold on these loans with fantasy projections of unending growth. Being "too big to fail" the lenders had incentive to gamble on making loans for short term gain.
If causing growth in a market by applying unrealistic criteria for expending credit is not creating a bubble what is it?
Two points. 1. I do not believe that money was too tight before the recession, I think it was too tight during the recession.
2. Tight money has nothing to do with tight credit. Don't conflate money and credit, two radically different concepts. You measure the stance of money by looking at NGDP growth---when it's too slow, then money is tight.
The Fed had been countering credit-funded demand by tightening the growth of currency, which kept NGDP growth stable before 2008. The subprime boom rose up in late 2003 and collapsed entirely by mid-2007. Then, in 2008, well after all that had happened, the federal mortgage agencies greatly tightened mortgage access at a much larger scale than the subprime boom had loosened it so that suddenly mortgage access was much tighter than it had been for decades. When they did that, the Fed did nothing to counter it, and the crisis in late 2008, the collapse in construction employment after that, and the slow recovery afterward were the result.
'The subprime boom rose up in late 2003 and collapsed entirely by mid-2007. Then, in 2008, well after all that had happened, the federal mortgage agencies greatly tightened mortgage access at a much larger scale than the subprime boom had loosened it so that suddenly mortgage access was much tighter than it had been for decades. When they did that, the Fed did nothing to counter it, and the crisis in late 2008, the collapse in construction employment after that, and the slow recovery afterward were the result.'
I didn't know they tried tightening. The must have finally woken up to the Sword of Damocles their affordable housing provisions had created. See my other comment on the subject.
High home prices are entirely due to high rents which are entirely due to supply constraints. At this point, there should be no debate.
Also, I would say your other comment begs the question. None of those programs were important factors in creating either a housing boom or the recession.
Unfortunately, for decades, urban land use restrictions have been making housing more expensive, and the economists, analysts, and politicians who should be the most vocal advocates for fixing it spent decades building up a false counternarrative focused on federal programs, lending, and interest rates. Two decades after 2008, 1/3 of the former mortgage market has been eliminated by federal regulators, and interest rates have risen substantially, but those old mistaken explanations are hard to let go of.
I see you've beaten me to it! I agree, but would argue that most of the constraints are imposed by political economics- government regulatory frameworks. I would argue that there is a distinct difference between affordable homes (bad) and housing affordability (good). Demand stoking government programs don't help the issue, because the residential housing sector doesn't fit the efficient market hypothesis.
Most people don't realise that as scarcity costs for building land increase, profit margins for actually building houses shrink- all the profits go to land development and husbanding land through an increasingly complex and burdensome government regulatory framework. In the UK, this particular market has become incredibly bifurcated. Many CEOs of Housing Associations (traditionally charities, or enjoying mutual status) now earn very impressive executive compensation, because of the money they make for private equity firms through land development. I'm not criticising them for that- merely the government created conditions that make it possible.
There is plenty of suitable land for building in the UK. The exclusion zone in London is filled with concrete covered wastelands of no environmental importance, with ready access to roads. But it's an Iron Triangle of Interest- and the last thing the Upper and Upper Middle Class people of Henley want is White Van Man moving into their area, his children invading their children's schools. America is somewhat different. There is huge potential to develop an entire generation of American starter homes. It would solve the population crisis. It would probably boost entrepreneurship, by changing the debt calculation of the younger generation. The only thing necessary is for government to reform itself, especially at the local level.
Pigs will probably learn to fly first.
One thing worth checking out is Swedish housing. Their private sector has done some really good work on making cheap great liveable prefabricated homes. About 50% of the work is now carried out off-site.
I would argue that today, on net, the government acts as a suppressor of mortgage access and that mortgage access is much more of a supply stoking factor than a demand stoking factor. Millions of new starter homes in lightly regulated smaller cities have not been built since 2008 because of the mortgage crackdown. The main effect of pre-2008 federal mortgage agencies was to lower rents because of their effect on single family housing supply.
"The subprime boom rose up in late 2003 and collapsed entirely by mid-2007."
In other words a "bubble"? That was "popped" in 2008 ?
Not really. I attribute about 8% home price appreciation from 2002-2006 to changing credit conditions. A blip. The rest was supply. The credit blip had reversed by 2008. Then the 2008 tightening caused aggregate home values in the US to drop by something like 20-25%.
Re housing bubble: I've calculated new housing completions relative to population growth for the 2000s. Look at these while recalling average household size around 2.5, which implies 40 additional houses for every 100 new residents.
Completions per 100 new residents:
2001 56
2002 62
2003 68
2004 68
2005 71
2006 69
2007 53
Looks to me like massive overbuilding.
Data sources: https://www.census.gov/construction/nrc/data/series.html
"Annual and Monthly Data, Housing Units Completed"
https://www.census.gov/construction/nrc/xls/comps_cust.xlsx
and
https://www.census.gov/data/tables/time-series/demo/popest/intercensal-2000-2010-national.html
"Intercensal Estimates of the Resident Population by Sex and Age for the United States: April 1, 2000 to July 1, 2010"
https://www2.census.gov/programs-surveys/popest/tables/2000-2010/intercensal/national/us-est00int-01.xls
Data limitations: excludes mobile home shipments and demolitions; completions data calendar year, population change July 1 to July 1
Cities with stagnant populations where rents are stable appear to typically build about 3 units per 1,000 existing residents to maintain stock because of depreciation and replacement needs. When you factor that in, the 2000s was a very moderate building boom. Much more moderate than the building booms of the mid-20th century.
Cochrane believes that if the public looses confidence that the government will adequately service the debt, they will plan that the government will inflate away the difference.
And he has a role for the monetary policy in his model.
I don't see that ngdp targeting is inconsistent with his model. But I'm not familiar enough with the model to completely assess.
But, of course you make a most compelling case about ngdp and the recession.
Yes, he has more of a fiscal theory of the price level. I disagree. I think monetary policy drives inflation, and fiscal policy is not really much of a factor in the US.
Nice post. Question from an ignoramus about #13. Why are wages sticky, and why is that stickiness the "glue" that attaches NGDP to RGDP? Is it wage-earners' susceptibility to the illusion that money has inherent value? Without which, wage earners would accept a pay cut as long as a price-level cut would occur that's at least as large?
Actually, Wall Street is even "stickier" than workers, as nominal debt contracts (bonds) often last far longer than wage contracts. Prices are also sticky. So I take stickiness as a given.
I use the "musical chairs model" as a metaphor for how stickiness causes nominal shocks to have real effects. NGDP is the total revenue that firms have available to pay workers. If NGDP falls unexpectedly, and nominal hourly wages are unchanged, then the number of hours worked will usually fall. Profits may also fall, but at least some of the burden will be absorbed by workers. The historical data very strongly confirms this claim.
Yes, Scott, what is actually sticky are the prices Wall Street pays for long duration assets. Money managers, including corporate planners, want price stability. And price stability is desirable.
Incomes & wages are not nearly as sticky as claimed or imagined. American businesses typically handle labor costs to match the business cycle of that business. For example, construction businesses have incredible wage flexibility and they hire and fire workers immediately, as well as add or reduce hours. Construction as with other cyclical businesses also rely on bonuses and the amount of bonus varies year by year.
There is a mountain of empirical support for sticky wages. It doesn't have to be true that all wages are sticky in order for wage stickiness to be a big problem. Your anecdotes are meaningless, no bearing on my claim.
Thanks, that makes sense. If we include mortgages and car notes as nominal debt contracts too, that explains why workers are sticky (though not as sticky as Wall Street)?
In 2008 the Federal Reserve felt constrained in bailing out failing financial firms. They allowed Lehman to fail and Wall Street threw a temper tantrum. So Wall Street got a bailout even though main street banks said they didn't need one.
In 2023 the Federal Reserve along with the Treasury offered unlimited intervention to prevent bank failures. US equities have soared and the economy has seemingly recovered from the 2022 post COVID stimulus lows.
However, by conventional accounting the Federal Reset is insolvent. Google AI explains: "Yes, the Federal Reserve is technically insolvent, meaning its liabilities exceed its assets. However, the Fed is able to continue operating because it can create money to cover its losses."
Privatizing gains, socializing losses. And that is exactly what we see playing out in the American economy! The agenda seems to be to never allow distressed selling. Prices must be stable and otherwise rise. To our overlords, stock prices and home prices are the economy!
This plan sounds perfect! Except how much market intervention is required? How much economic distortion does it create?
I basically agree with this, but it's a different topic from my post. My post discusses the cause of the 2008 recession, not problems with the financial system. The two issues seem related, but are actually mostly unrelated.
I think we want monetary management to have separation from economic activity but the nature of credit creates a dependency. When credit is emitted in anticipation of economic gains, who holds the bag if what is anticipated does not come to pass?
The Federal Reserve appears to have embraced the idea that if it can prevent credit crisis then it can achieve monetary stability. Does it not occur to anyone that this "guarantee" invites ever greater speculation and ever greater credit expansion?
It is observed knowledge that a way to mitigate massive forest fires is to have more frequent, smaller fires. The Federal Reserve has opted to avoid any clearing of dead assets - lest there be a credit crisis. Thus, when the next credit crisis hits it will be much larger and much more damaging.
I wish I could believe otherwise but I don't believe a risk free world exists - yet the Federal Reserve surely believes it can cover all financial risk and prevent anyone from getting hurt from collapsing credit, even when the credit goes bad because it was based on a serious blunder and miscalculation.
By the way, in 2008 the fastest way to recovery would have been to let assets and debt be repriced lower. Let the imprudent fail and let the wise profit from that failure. Instead we ended up with QE and a decade of subsidized interest rates, as well as overregulation of the credit markets (Kevin Erdmann is correct about this) that have yielded a massive distortion in the economy. But in response to Kevin, if the Fed is going to guarantee debt, then don't be surprised if the politicians heavily regulate who deserves it!
I agree that we need to get rid of moral hazard, but this has no bearing on my post. Moral hazard did not cause the Great Recession, tight money did.
I am trying to reconcile 14 and 9. It is easy to imagine both the fed and ecb making the same errors of omission at the same time as a failure to respond to some global change. What errors of commission would they have made at the same time and what might have been the root cause of them both doing that?
I only recall hearing talk of central bank coordination after the troubles began. Have they always been doing this?
Central bank mistakes are correlated, but not perfectly correlated. (For instance, China did not have high inflation post-Covid.) The policy mistakes are somewhat correlated because they all tend to operate with the same flawed interest rate targeting approach. If you are targeting interest rates, and the natural interest rate declines without the central bank noticing, then policy can easily become more contractionary than the central bank intended.
Okay, it sounds like you are saying the error of commission was letting M growth fall as the interest stayed fixed. Its easier to just agree the policy framework is flawed then dissect the difference between omission and comission
There was no growth in our means-of-payment money for 4 years. That is the most contractive money policy since the GD.
I recently re-read The Money Illusion and I appreciate this summary of some of your main claims. The book has a lot of detail on your ideas of how the crisis happened and lots of accompanying data, but I found that much of the story is discussed in depth across few different chapters; having the pieces in one place is useful.
One thing I still don't understand about your model though is where the tight monetary policy came from in the first place. If the causation is X -> tight money -> recession -> subprime loan/banking crisis, what is X? I'm sure this is in your book somewhere but I must have missed it.
See reply to Andrew above. In addition to the natural interest rate problem, you also had a big commodity price spike in 2008 (due to China's boom) which led central banks to become overly concerned with inflation, at a time when they should have been focusing on slowing NGDP growth.
BTW, I really appreciate your willingness to reread the book. These sorts of books require a lot of work, and earn very little in royalties. So I am gratified any time someone takes the time to read the book.
Here's a thought. Write down a model in the language of science, which is mathematics. That model will have equations. Those equations will have parameters. Those parameters are constants. If they are constants that can be measure, then measure them.
I am confident that no such model can be or ever has been written down. Why? Because macroeconomics is a collection of epiphenomenon and because there are no constants in human behavior.
NGDP is the sum of millions of Ps x Qs added up (I could write that out mathematically just about anywhere else using standard mathematical notions, but not in a comment on Substack). If most of the Ps are going up and most of the Qs are not, or might even be falling, what's the secret sauce of juicing the Ps by creating additional money? No hand waving allowed. Write down a model. Then we can all examine it.
For comparison:
We can predict the long running statistical distribution of dice rolls just fine, we don't need to have a model of air resistance, bouncing off the table or physiology of the human hand.
Yes, we would need all these details to predict how any one die roll plays out. But it's pretty irrelevant for the statistical distribution. That distribution is a collection of epiphenomena.
Your original assertion that economics is hard (or even impossible) to properly model might still be correct, I don't know. After all, it's easy to come up with invalid arguments even for correct assertions.
I didn't say economics; I said macroeconomics. Rolling dice and probability distributions that arise from it are completely deterministic, not by some magic, but by the simple concept of relative frequency. Air resistance isn't involved in the least, nor is the physiology of a hand. There is no analogy with aggregates of Ps and Qs and dice.
I wrote a book explaining my model. You are free to examine it if you wish. You are also free to ignore it. But don't waste time trying to convince me of your narrow-minded theories of epistemology. The dogs bark, the caravan . . .
Kind of what I expected you would say, instead of addressing the important point about no constants to be measured. Keep looking for the lost ring under the street light, right? Where's the caravan going? So far as I can see over the past 50 years, no where.
Incidentally, I'm not trying to convince you of anything. Just putting out an idea that you didn't respond to, for whatever reason.
Constants? I didn't see any coherent point worth responding to. Must have missed it.
Tell me some constant that you are aware of in some economic model that is actually a constant. What is incoherent about that question?
Irving Fisher's transaction concept works.
Please address bank leverage as a possible contributor in so far as banks originated, packaged and securitized any number of loans, particular mortgage loans that were not on their balance sheets and ability to do so may have had to do with too much leverage in the banking system.
Had Greenspan at the time said to bank heads to sell off loans or raise equity is it not possible that this might have lessened the GFC if not avoided it in its entirety?
Across the globe banking institutions and others were seeking the highest risk adjusted instruments and banks in say Scandinavia bought any number of securitized bond and tranches of these instruments, and inter bank lending was also large.
I see the banking industry as a culprit and much related to securitized loans. thanks.
"Please address bank leverage as a possible contributor"
Contributor to what? If this post were on the financial crisis, I'd certainly discuss excessive bank leverage. But it's not. The post is on the Great Recession, which is a different issue from the financial crisis. That's why I ignored bank leverage. I'm trying to explain what caused the Great Recession, not consider symptoms of the Great Recession.
Yes , my bad for reading the post too fast while trying to do something else. Multitasking has its sins. oops, and sorry about the confusion.
If total nominal spending in the economy (= ngdp) is help stable, a reshuffle of the banking system one way or another doesn't cause a recession.
Leverage isn't special. Banks (and every other company) have to finance their balance sheet somehow. They typically use a combination of debt and equity, but there's nothing magic about either option.
Btw, common wisdom has is that the problem with too much leverage is that the eventual deleveraging. You suggested 'solution' would force that very problem, not avoid it.
As Scott says in his post, companies and customers service loans out of their nominal income (= ngdp). As long as that's held stable, they can in aggregate service their loans.
Awesome, this is very useful. Will definitely be sharing this.
> Real interest rates also move around for a wide variety of reasons, not just monetary policy.
There are related problems in the study of dynamic systems where a variable has an important relationship with a process, but is also influenced by things outside of that process in a way that sometimes confuses observers about the causal relationships. For example, your motor behavior is caused by neuromotor signals, but is also influenced by gravity and mechanical forces outside of your brain's control. The same mistakes economists have made are mirrored elsewhere, I think.
PS, Bucks will be fine, just need to follow Mavs and trade Giannis to the Knicks for KAT and a first.
Good example, also the speed of the car depends partly on accelerator pressure, but the "speed policy" is also influenced by wind, hills, etc.
"trade Giannis to the Knicks"
I've permanently banned people for far less offensive takes. :)
Scott, please define "fiscal austerity began in January 2013". Which form did it take?
Both tax increases and spending cuts. This reduced the deficit from about $1050 billion in 2012 to about $560 billion in 2013. Note that I use calendar data, not the more widely available "fiscal year data". That's because the austerity started January 1st, 2013.
Thanks for the reply. Do you have a source from which I can learn more?
Here's a long post that discusses the debate that played out at the time:
https://www.themoneyillusion.com/kevin-drum-on-market-monetarism/
A belated thank you.
Does your account re Europe take into account that many banks (such as Landedbanks in Germany) were heavily invested in U.S. RMBS?
Yes. I don't deny there were ripple effects from our banking problems in Europe, but initially it was widely expected that the recession would be much milder in Europe, because people wrongly thought that financial turmoil was causing the recession. Actually, it was tight money. If the actual problem was financial stress, then the recession would have been far worse in America.
I guess this where I’m getting stuck: why would rescission have been much worse in US if Euro banks also had significant exposure to the very same issues affecting US banks?
It's a question of degree. Yes, European banks had some exposure to the US market, but nowhere near the exposure of US banks. European banks tend to focus on Europe, and US banks tend to focus on the US. Again, I'm not denying some ripple effects, but you'd certainly expect the primary hit to have been to the US banks.