What really happened in 2008?

My most contrarian view

I believe that the Great Recession was caused by a tight money policy during 2008. Probably fewer than 1% of economists agree with me. Most blame the housing slump and the subsequent banking crisis.

I recently gave a talk to a group of people at the Less Online conference in Berkeley. Because the audience was mostly composed of extremely bright non-economists, I thought it made sense to avoid a lot of technical data, and instead use analogies to explain why I held such a contrarian view as to the cause of the Great Recession of 2008-09. Here’s how I made my pitch.

Consider this old anecdote:

“Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?”

I will try to get you to rethink 2008 in a roughly analogous way.

I have a nearly 400-page book making the case for my interpretation, but here I’ll use a few analogies and examples to provide the basic intuition for my claim. Today’s objective is not to prove that I am correct, rather I aim to convince you that it’s a plausible argument, not an obviously far-fetched theory.

Unlike the recent Covid recession, the 2008 slump was in many ways a garden variety recession, caused by a sharp drop in aggregate demand. Of course, the drop in spending is only the proximate cause of the Great Recession, the real debate is over the deeper causes—why did spending fall so sharply?

To use a WWII analogy, the German invasion of Poland was the proximate cause of WWII in Europe, but historians tend to be interested in the deeper causes of the conflict.

The conventional view is that the deeper cause of the Great Recession was the combined effects of a housing market crash and a banking crisis, which triggered a large fall in spending.

My view is that the deeper cause of the Great Recession was a contractionary monetary policy that caused nominal GDP growth (total dollar spending) to fall from the previous growth rate trend of 5%/year to negative 3%. The Fed caused the Great Recession with tight money.

Note that both sides agree that falling aggregate demand was the problem, but we disagree as to what caused this decline. I say the Fed could have and should have kept NGDP growing at 5%/year after 2007, but failed to do so. The conventional view is that it indeed would have been desirable to see NGDP continue growing at 5%, but the Fed was not to blame for failing to do so.

Here I need to digress and address the tricky issue of causality. What does it mean in macroeconomics to say that X caused Y? Some people think it’s weird to claim the Fed caused the recession, when at best I seem to be claiming that they failed to prevent the recession.

Consider a bus traveling on a long straight highway. Eventually the bus reaches a bend in the road and continues straight on into a ditch. The driver was on his cell phone, not paying attention to the road. How would police officers establish blame for the accident? Would they attribute the accident to highway engineers putting a bend on the road, or blame the inattentive driver?

I am a philosophical pragmatist, and thus am interested in the most useful definition of causality. Consider the previous WWII example. One could imagine a plausible counterfactual where no Hitler meant no WWII, but does it make sense to assert that Mr. and Mrs. Hitler having a baby named Adolf actually caused the war. I would argue that most useful causal explanations of WWII relate to things that public policy can address, such as the Great Depression of the 1930s, US isolationism and the rise of European nationalism. Western leaders seemed to agree, as the post-war period saw the creation of Nato, the creation of the EU, and the aggressive use of fiscal and monetary policy tools to prevent a repeat of the Depression.

[Killing babies that might become future leaders is not an effective public policy, as King Herod learned.]

So if optimal public policy X can prevent a recession, not doing policy X caused the recession, just as the bus driver not turning the steering wheel at the bend in the road caused the accident.

My view of causality in the bus accident example is generally accepted. So why is my view of the Great Recession so controversial? It seems that mainstream economists reject my claim that the Fed could have easily prevented the sharp decline in aggregate demand. To explain why I’ll use another transportation analogy, this one involving a ship.

Imagine a ship going from France to America. Because of wind and waves, it ends up in New York rather than the intended destination of Boston. Is the captain to blame, or did wind and waves cause the ship to move off course? The bus analogy would suggest the captain should have adjusted the ship’s rudder to counter the wind and waves. But perhaps the northern gale was so strong that the ship’s engines were not powerful enough to fully offset the wind and waves.

My critics argue that the Fed lacked enough “ammunition” to prevent aggregate demand from falling sharply. I argue that while this argument might apply to a central bank operating under a gold standard, as during the Great Depression, it certainly does not apply to a modern central bank using fiat money. Unless the Fed runs out of paper and green ink, they have essentially unlimited ability to boost nominal GDP by printing money.

I claim the Fed could have and should have continued steering the economy along a 5% NGDP growth path. Their failure to do so caused the Great Recession. My critics raise two objections.

One argument is that the housing slump and banking crisis were severe real shocks that would have caused a recession even if NGDP had kept growing at 5%, just as Covid likely would have caused a recession even with sound monetary policy. But before the tight money began, housing had been slumping for nearly two years (during 2006 and 2007) without any significant negative effect on the broader economy. And the post-Lehman banking crisis was largely caused by a recession that began nine months earlier and was itself caused by tight money. More a symptom than a cause.

In a counterfactual where the Fed kept spending growing at 5%/year, the banking crisis would have been far milder, analogous to the March 2023 banking crisis when Silicon Valley Bank and First Republic Bank both failed. Many economists thought this smaller crisis would slow the economic recovery, but it did not. Economists tend to overestimate the importance of real shocks. Today, the 2023 banking crisis is largely forgotten. As an aside, the initial Trump tariffs might have been a severe enough real shock to have caused a mild recession, even if the Fed maintained 4% or 5% NGDP growth. The new reduced tariffs will be unlikely to cause a recession unless the Fed fails to maintain adequate spending growth.

Along similar lines, the 1929 stock market crash is more famous than the 1987 crash, even though the latter was almost identical in magnitude, occurred much more recently, and occurred at a time when far more Americans owned stocks. The explanation is simple. After the 1987 crash, the Fed adjusted monetary policy to keep NGDP growing at a steady rate. The economy not only avoided another Great Depression, there was no economic slowdown at all. The 1987 crash shows that the Fed can and should adjust monetary policy to prevent financial turmoil from impacting the broader economy.

In early 2008, there was a bit of gloating in Europe over the fact that America seemed to be about to pay the price for decades of reckless “cowboy capitalism”. For years, we had been lecturing the rest of the world on the need to deregulate their economies, the so-called “Washington Consensus”. The US economy had been riding high, and we all know how obnoxious Americans can become when they start bragging. Now we were about the pay the price for all that deregulation.

Initially, many pundits expected the recession to be far worse in America than in Europe. And it would have been far worse, if in fact it had been caused by the housing slump and the banking crisis. But it wasn’t. Europe experienced an even worse Great Recession, because Europe had a more contractionary monetary policy than the US.

[As an aside, in terms of economic policy, Europe is more right-wing (i.e., hawkish) than America on monetary policy and more left wing on government spending and regulation. They’d have been better off with the reverse, more dovish monetary policy and a more capitalist policy regime.]

So why do my critics reject my claim that the Fed could have prevented the sharp decline in spending? The primary issue seems to be the zero lower bound on interest rates. Most central banks operate monetary policy by targeting interest rates. I think that’s foolish, but I don’t get to set the rules. When nominal interest rates fall to zero, central banks are not able to cut them much further (at best to slightly negative levels.) Conventional economists see this as the point when central banks run out of ammunition, become unable to stimulate the economy.

In fact, a central bank has numerous other tools to stimulate spending when interest rates are stuck at zero, so I reject the claim that a modern fiat money central bank could ever run out of ammunition. I could cite numerous arguments and examples to support my claim, but I’ll conclude by just mentioning a few.

To begin with, the US was not at the zero lower bound during 2008, at least before mid-December, by which time the worst of the economic slump had already occurred. So even if you accept the erroneous claim that a central bank at the zero lower bound is out of ammunition, the Fed was clearly not doing all it could to boost spending during 2008.

My critics will often respond by claiming that even if the Fed had adopted monetary stimulus before December 2008, it would not have been enough. I don’t agree, as the ongoing severe decline in the economy was caused by a previous tight money policy by the Fed. But let’s say I’m wrong, and let’s assume that we would have quickly hit the zero lower bound with a more expansionary policy during 2008. What then? It turns out that there is a great deal of evidence that the zero lower bound does not prevent monetary stimulus. I’ll cite two examples from 2013.

In late 2012, Congress adopted a policy of fiscal austerity, which reduced the budget deficit dramatically, from roughly $1060 billion to $560. This austerity began right at the beginning of 2013. Many Keynesian economists predicted a sharp slowdown in the economy, as the economy was still stuck at the zero lower bound for interest rates.

Market monetarists like myself suggested that the fiscal austerity would be offset by a more expansionary monetary policy, including unconventional tools such as QE and (most importantly) forward guidance. Paul Krugman was skeptical and suggested that this would be a test of market monetarism. In fact, nominal GDP growth sped up in 2013, so we passed the test with flying colors. Eliezer Yudkowsky cited this example in Inadequate Equilibria.

Also in late 2012, Abe was elected Prime Minister of Japan on a platform of higher inflation. He combined fiscal austerity with monetary stimulus. Again, conventional economists were pessimistic. Japan had been stuck at the zero lower bound for much longer—roughly 15 years, and people there were especially pessimistic about the prospects of offsetting fiscal austerity. But it worked. The Japanese monetary stimulus offset the Abe tax increases, and the Japanese economy began to improve modestly.

These examples are just the tip of the iceberg. My book entitled The Money Illusion includes many more such examples.

So why does my view remain so unpopular among economists? Monetary economics is a sort of Alice in Wonderland world, where nothing is quite what it seems. Low interest rates can represent easy money, but usually they do not. Quantitative easing can represent easy money, but usually it does not. Because monetary policy operates in such a counterintuitive fashion, it often gets misinterpreted. If a tight money policy is misjudged as easy money, it will not be surprising that economists become pessimistic about the prospects for easy money to stimulate the economy.

Let’s return to the opening analogy:

Wittgenstein: Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?

Friend: Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.

Wittgenstein: Well, what would it have looked like if it had been caused by a contractionary Fed policy that caused nominal GDP to fall at the sharpest rate since 1938, given that the resources for repaying nominal debts come from nominal income?