this Recession: cause and cure

The severity and depth of this recession wasn't caused by the financial crisis, or the housing market.

The housing bubble started bursting in 2006, banks somewhat later, but real GDP rose almost continuously thru middle of 2008. It's after that demand started sharply falling across a wide sprectrum of industries.


As economist Scott Sumner wrote: "The prevailing view was that the financial system was the fundamental problem and falling demand was a symptom. I never understood this argument, as modern macro [economic] theory says falling AD [aggregate demand] is a symptom of monetary policy that isn’t expansive enough. Now perhaps things are getting bad enough that people are beginning to understand that it does no good to bail water out of a boat if it is coming in even faster through a hole in the hull."


Sure enough, monetary economists that monitor the Federal Reserve were getting alarmed in 2008 at the contraction of the money supply that was taking place.

Looks to me like the Fed was belately responding to criticism that their "easy credit" policy (targeting nominal GDP at 5% instead of 3% or so--NGDP is GDP plus inflation) was fueling the housing boom, and they responded like they have alot in the past--slammed on the brakes too late and too fast. This caused big drop in AG and slammed the housing and banking sectors, already in crisis, in a big way.


The Fed was also trying out some new and untested ways of using monetary policy to affect the credit markets at this time too. James Hamilton, a very mainstream macroeconomist, wrote about this in his popular blog.


I'm not saying the problems in housing and banking aren't relevant. In hindsight, politicians of both parties fixing and pushing entities so unqualified buyers could obtain mortgages was dumb (but that doesn't explain why the smartest guys from ivy league schools running the biggest investment firms thought it was brilliant to pour hundreds of billion dollars into these mortgages). Large problems in sectors like that can cause GDP and price changes, though historically not big ones. But they can't affect the NGDP--that's entirely the creation of the Fed.

That nominal GDP and nominal prices falling to the negative levels by 2008 wasn't anything a rational mortgage investor would have predicted in 2006. Plus, even if rapidly expanding the money now it does't help boost a rise in real GDP soon--the rising nominal prices will at least help the balance sheet of the banks in a big way, instead of killing them.


So yes, I think this recession, or mild depression, is mostly (tho not all) the result of bumbling Federal Reserve policies: tight money caused the NGDP to plumment, stabbing the housing and finance sectors at almost the worst possible time. The Federal Reserve has done this before. Even Ben Bernanke, a renowned academic scholar on the Fed, acknowledges that the Federal Reserve caused the Great Depression.


As I've said before, we won't know for years the full story of this crisis and it's causes. But examining the evidence across a wide range of opinions, I think this explanation is the one that will hold. Though it is a very, very minority opinion! Even so, some economists might not agree that tight money is what turned this housing/finance caused slowdown, or mild recession, into a depression--but many of those economists do see the need for monetary stimulus. The monetary economist Scott Sumner (from whom I've stolen alot for my post here!) argues for unconventional monetary stimulus to be used in a big way now. Even liberal economist Paul Krugman has recently called for it (tho he still puts old-fashioned Keynesian fiscal stimulus first on this list)

The Federal Reserve has increased the monetary base by gobs in recent months, but looking at inflation and it's long term expectations (that is, the CPI and TIPS- 10 yr TIPS today is at implied 1.40% inflation, up 40 bps recent weeks) increases in MB ain't moving things much. Plus, some other usual routes for them to increase money supply are closed due to 0% interest rate. Hence the call for unconventional monetary stimulus. For those folks worried about hyperinflation, Weimar or even Zimbabwe style, Sumner had a good post on that.

It's only after this monetary stimulus, and wringing all the resulting AG increase we can get from it, that bank's balance sheets will improve, that banks can get lots of folks to loan funds to--and we can do some effective fixes in the banking and housing sectors.