What Both Progressives and Conservatives Missed

Progressives and conservatives disagree as to what caused the crash of 2008.  Progressives tend to blame the instability of unregulated capitalism, prone to bubbles and crashes.  Conservatives blame moral hazard created by government insurance and/or policies that tried to get more low income people into housing.  But both seem to see the sub-prime crash as the proximate cause of the crisis of late 2008.  I think they are both wrong.

In my view the sub-prime crisis of early 2006 to mid-2008 caused only a small rise in unemployment, and manageable levels of debt default.  Rather the severe crisis was caused by a sharp fall in AD, a monetary policy failure, which began in mid-2008.  Here’s what my theory explains, which the standard progressive and conservative explanations fail to explain:

1. The crisis spread to the sovereign debt of numerous countries, both with and without banking system collapse.
2. The crisis spread to state and local government debt and pensions.
3. In late 2008 the crisis spread to commercial real estate, which was less affected by pro-housing government policies.
4. In late 2008 the crisis spread to the housing market of states that never experienced a housing bubble, like Texas.

A fall in nominal spending, if severe enough, will cause all of those problems.  Housing bubbles, the GSEs, the CRA, etc, cannot explain why all those problems suddenly developed after late 2008.

I’m depressed by almost all discussions of the current crisis, as they all start with the premise that “it goes without saying” that the Great Recession was triggered by financial crisis.  No, the Great Recession caused the financial crisis, just as the Great Depression of the 1930s caused a very similar pattern of financial crises.  Ditto for the early 1980s, to a much lesser degree.  We didn’t know it at the time, but we now know that NGDP and employment started falling sharply before the severe financial crisis of the fall of 2008.

Only the original sub-prime crisis, as well as a few other housing crises in places like Iceland, were exogenous events not caused by tight money.  Those weren’t even close to being severe enough to have caused our current problems.

A severe drop in NGDP growth will cause a major recession, and it will severely damage balance sheets.  Many people think balance sheet distress causes recession.  They are confusing cause and effect.

In 1929 we were rich, and by 1933 we were much less rich.  We didn’t falsely believe we were rich in 1929, we really were rich.  We became poorer over the next 4 years.

In 2006 we thought we were really rich.  Some of this was a mirage, as Tyler Cowen likes to point out.  But not all.

Between 2006 and 2008 we gradually became more aware of the amount of wealth we actually had in 2006.  We had built unneeded houses.  By mid-2008 we had a fairly accurate understanding of our wealth.  Then between 2008 and 2009 we lost a lot of wealth that we really did have in 2008.  That’s a very different problem.  That’s a smaller example of 1929-33.

In 1929 we were producing lots of things like cars, homes, home appliances, roads, office buildings, factories, food, clothing.  These are exactly the things a rapidly developing country should be producing.  We were rich.  Then for 10 years we stopped producing much of this output.  We became poor.  After the war we started up again, and found we needed lots more of exactly what we were producing 1929; cars, homes, home appliances, roads, offices, factories, food, clothing, etc.  And we became rich again.

Is it possible to have a major “balance sheet recession” or “reallocation recession” without a sharp drop in NGDP growth?  Maybe–but I don’t expect to live long enough to see one.