Could We Have Had a Severe Recession Without the 2008 Financial Crisis?

Paul Krugman argues that it would have taken a dramatically different set of policies back in 2007 to prevent the Great Recession, and Brad DeLong argues that a much more modest set of initiatives might have sufficed. There is much to agree with in both posts. First here’s Krugman, quoted by DeLong:

What It Would Have Taken: “Think of it this way: what would a really effective set of policies be right now? First… aggressively reverse the fiscal austerity of the last few years…. Monetary policy should accommodate that boost; interest rates should not go up even if inflation goes somewhat above 2 percent. In fact, there’s an overwhelming prudential case for raising the inflation target…. Say for the sake of argument that the right policy is two years of fiscal expansion amounting to 3 percent of GDP each year, plus a permanent rise in the inflation target to 4 percent. These wouldn’t be radical moves in terms of Econ 101 — they are in fact pretty much what textbook models would suggest make sense given what we have learned about macroeconomic vulnerabilities. But they are completely outside the bounds of respectable discussion. That’s the sense in which we are “doomed” to long-term stagnation. We have met the enemy, and it’s not the economic fundamentals, it’s us.

And here’s DeLong’s reply (or more precisely the response of Brad’s Greek friends):

Thrasymakhos: Oh, Krugman’s 100% right about today…

Khremistokles: He is indeed. We are totally tracked…

Thrasymakhos: Very few members of congress or FOMC participants seem to spend any significant time talking to anybody who is not a plutocrat…

Khremistokles: But he is wrong about how aggressive and radical the needed policies back in 2007 were. As a share of GDP, the bad shopping-mall and office-tour debts of Houston, etc, in 1989 were as large as the bad mortgages of 2007…

Thrasymakhos: But back in 1989 the political power of the princes of finance was much less than in 2007…

That’s probably right, but I have trouble with DeLong’s implicit assumption is that the financial crisis caused the Great Recession. DeLong points out that the recession of 1990-91 was far milder, despite equivalent bad debt (as a share of GDP.) And that the 1990 crisis was handled better. Krugman’s comment points to one overlooked factor. In 1990 we did have a de facto 4% inflation target. The years leading up to 1990 saw Australian-level NGDP growth, if not more. So even if lending standards tightened sharply in the wake of the 1989-90 crisis, there was no possibility of hitting the zero bound. Rates fell to about 3% in the recession, still a bit higher than in Australia this time around. With no zero bound in prospect, there’d be no reason for markets to expect an NGDP collapse. Elsewhere I’ve argued that growing realization of plunging NGDP tanked the asset markets in the second half of 2008.

Even if we had managed the 2007-08 subprime crisis very well from a regulatory/resolution perspective, there is no question that banks would have tightened lending standards sharply. That effectively reduces the demand for credit. And of course house prices were plunging even before Lehman, and then we got a “secondary deflation” of house prices when NGDP plunged. It’s quite plausible that the Wicksellian equilibrium natural rate would have fallen to zero in late 2008, even with a better resolution of the banks. On the other hand if we’d gone into 2007 with Paul Volcker’s de facto 4% inflation target (a policy he now opposes), then the Great Recession would have been a 1990-style mild recession.

One area where I slightly disagree with Krugman is his focus on inflation. A 5% NGDPLT target path would have been enough, we didn’t need 4% trend inflation. Nor do we need fiscal stimulus. On the other hand the supply side fundamentals of the economy were so poor after 2008 (for reason I don’t fully understand) that 5% NGDP growth would have led to some unpleasant stagflation. So we might have gotten Krugman’s 4% inflation anyway. Indeed if my preferred policy had been adopted, it would have been widely judged a failure, partly because (as DeLong correctly pointed out) almost nobody back in 2007 envisioned a recession as severe as the one we got.

People see bad outcomes, and have trouble envisioning it could have been much worse. That’s one reason why my preferred policy was not politically feasible in 2008. But thanks to the NGDP targeting boomlet, it will be somewhat more feasible next time around. Next time people will be able to envision a worse alternative.

All stabilization policies eventually fail, just as all presidents are judged failures in their 6th year in office. The trick is to have a modest failure like Clinton or Obama, not a serious failure like FDR or Nixon. NGDPLT would have given us just that in 2008-09.

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