I recently had lunch with a guy who is very bright, and pretty well-informed about economics. He had seen Inside Job and immediately spotted the flaws. He started lunch by asking me what I thought about the crisis. I said; “do you want to talk about the financial crisis that took place three years ago, or the current problem of recession and 9.2% unemployment?” He responded that most people see the two as related, that one led to the other.
I asked why a financial crisis in 2008 would cause high unemployment in 2011. He talked about the loss of wealth, that people were cutting back on their spending—basically an AD-side explanation of the recession.
I pointed out that he was confusing “spending” (i.e. consumption), with aggregate demand, which involves all types of output. It’s not immediately clear that less consumption means less AD. After all, savings equals investment, and investment is part of AD. Less consumption is more saving, which means more investment. At this point the Keynesian readers will be throwing bricks at the computer screen, we will go through a long fruitless discussion of planned and unplanned, and end up with the conclusion that more saving depresses interest rates, which lowers velocity, which lowers AD. Fair enough.
But that would be equally true if the collapse of the Soviet Union led Russians to hoard $100 billion in US base money. Yet I doubt you’d find a single economist arguing that that action would cause a recession. The reason is that if the Fed were targeting interest rates, rather than the money supply, the Russian hoarding would be smoothly accommodated by the Fed, and NGDP would remain unchanged. In contrast, the financial crisis led to velocity falling at a given interest rate, and thus the Fed might have needed to drive real interest rates much lower in order to prevent the rush for savings from lowering AD and NGDP.
Even so, they did have the power to prevent NGDP from falling 10% below trend in 2011, Ben Bernanke just reiterated that point yesterday. So why does the banking crisis in 2008 cause low NGDP in 2011? And then it hit me. The intelligent but uninformed analysis of my non-economist friend had become the OFFICIAL DOGMA of the economics profession. To deny that the banking crisis of 2008 causes the low NGDP of 2011 makes you a heterodox economist. Out on the fringes.
And here’s what’s even more interesting. I’m simply doing mainstream economics, right out of all the textbooks. The rest of the profession is making it up as they go along. Go back and look at your economics textbooks, and see where is says a banking crisis will cause NGDP three years later to be far below the level the Fed wants it to be at. You won’t find it. You’ll find 100s of models explaining how the Fed determines the path of NGDP. But nothing about how banking crises make it impossible for the Fed to determine NGDP three years later.
You might be thinking; “But didn’t Bernanke argue the banking crises made the Great Depression worse?” Yes he did, but he was also very critical of the Fed. He argued that once the US cut the tie to gold, they had essentially unlimited ability to raise NGDP. And of course in this crisis Bernanke has never once argued that the banking crisis prevents the Fed from raising NGDP three years after the crisis—just the opposite.
But that’s where we are. The common sense view of AD, that when America suffers great losses, it is important for millions of Americans to go on 99 week “vacations” in order to “rebalance” the economy, has become official dogma.
You might argue that the recession is structural. Yes, that’s possible, but nevertheless the official dogma is that demand is low because Americans are broke. That’s not structural, that’s AD. We have way too many houses, with no one to move into them. No one except the millions of 20-somethings that are doubling up in their parent’s house. And why are they doing that? Because they are broke, they have no jobs. And why do they have no jobs? Because there’s no AD, because Americans are broke. And why are Americans broke? Because we built too many houses, so their value fell. No one to live in those houses. No one except all the young people who can’t afford houses because they have no jobs because there’s not enough AD. And we all know the official dogma says there’s nothing the Fed can do about that lack of AD. That’s how the banking crisis of 2008 mysteriously causes low NGDP in 2011.
In the future we should just let non-economists write our textbooks; at least if we plan on adopting seat-of-the-pants, common sense views as the OFFICIAL DOGMA of macroeconomics.
BTW, during the decade of 2001-11 housing construction in America was well below normal. Too many houses or too little income?