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Monday, November 23, 2015

What caused the Great Recession ?

A short comment on a shorter comment on Krugman's short comment on "The Big Short"

Comment FSP asked a question

FSP Los Angeles 41 minutes ago My question is this: Would the Lesser Depression have occurred if we did not have the "financial superstructure" of sub-prime backed securities, and just had instead the bursting of a housing bubble, without the implosion of those financial products adding to the problem? Or, can the two not be separated? I think at least a rough attempt to separate the two factors (housing bubble and financial superstructure) can be managed. Dean Baker has definitely claimed that the lesser depression would have occurred without the financial superstructure

The rough approach (Baker's approach) is to look at the much smaller past fluctuations in housing prices back before the RMBS CDO CDS superstructure was built and the subsequent fluctuations in GDP and employment. Baker argues that GDP behaved as one would forecast based on housing prices and regressions with pre-superstructure data.

Or you can ask if the financial crisis would have caused a lesser depression even if triggered by something other than a bubble bursting (a bubble in house price or some other price). Here the standard variable is the quality premium on corporate bonds (the spread between say a B corporate bond rate and AAA bonds or treasuries). This spiked in late 2008.

The time series of the two candidate explanatory variables are very very different. The lag, magnitude and duration of the effects on GDP can be estimated with 20th century data.

This is crude, but not as bad as my knowledge of the literature. I know of people (Del Negro & Schorfheide 2012 ) who look at quality premia and what happened next. I know of Baker who looks at house prices and what happened next. I (amazingly) don't know of anyone who has let the two variables into the same regression.


Anonymous said...

Is the question about specific financial innovations , or about over-lending in general ?

I think it's hard to separate over-lending from housing bubbles that ultimately burst - I doubt there are many historical examples of the latter that weren't preceded by the former. Mian and Sufi have demonstrated the connection beyond doubt for the U.S. bubble.

You don't need the fancy vehicles to get the over-lending , though I'm sure they make it easier. Spain used pretty much plain vanilla loans to developers to blow themselves up. BTW , Baker's 2010 column highlighting widespread praise of the Spanish financial sector needs to be , uh , updated , based on subsequent events.

Other bubbles , like the 2000 dotcom bust , seem to be less damaging than housing bubbles , which aligns nicely with the fact that business investment is less sensitive to interest rates than is housing.

The worship at the altar of the "wealth effect" by the likes of Greenspan , Farmer , and Baker would be amusing if it weren't so damaging to the rational discussion of policy choices. As ALL assets gravitate to ownership by the top 1% , the wealth effect will become even more insignificant than it is now. See , e.g. :


Robert said...

It is certainly true that countries have managed bubbles and great recessions or depressions without the new financial instruments. Spain is an example as the original great depression.

I think the question which can be answered is was the financial crisis the key explanation. A country can have over lending without a financial crisis. Here by financial crisis I mean lack of confidence in the key systemically important financial firms (which were unwilling to lend to each other).

I don't think there was such a crisis in Japan when their bubble burst in the 90s. I'm not sure if there was one in Spain (I know there were bank rescues but I don't know if all the bankers feared that all the other banks were insolvent). In the USA the financial crisis didn't last very long. I think it started when Lehman collapsed and I'd say it ended in the Spring or Summer of 2009 (say about when the Fed implemented QE1).

There can be over-lending without a financial crisis. This can happen if banks have ample capital (and pigs fly) but it can also happen if the over-lenders are easily identified. The S&L mess of the late 80s and 90s wasn't a systemic crisis.

Anonymous said...

I'd tend to agree with Baker that the financial crisis itself , using your reasonable definition , wasn't the "cause" of the great recession. I think that's probably true most of the time in advanced economies , but that may simply be a function of the response by gov'ts and CBs , which since Bagehot have done whatever it takes to save the banking system (using legal means preferably , if not exclusively).

Still , even in the absence of the collapse in confidence within the financial system , I don't think the over-lending could have continued indefinitely. There would have been a similar realization that many of the loans on the books would go bad , and a rational response would be to stop making bad loans. The housing price decline and its ramifications would have followed , probably in much the same way.

The S&L crisis is a good example , although at much reduced scale. Texas was probably the epicenter , and IIRC , they were bailed out to the tune of about one year's worth of Texas gdp at the time. For them , it was systemic , or would have been absent a powerful helping hand.

I don't think loan crisis prevention should be all that difficult. When the debt stock of the private sector , or any particular subsector , is growing faster than the corresponding incomes , quarter after quarter , it's time for the regulators to start taking a closer look. Both the S&L mess as well as the subprime crisis could have been nipped in the bud much earlier by keeping an eye on a few FRED charts , essentially. Our problem is this free-market-knows-best mindset that handcuffs any attempt to empower regulators to take away the punch bowl.


J. Edgar Mihelic said...


would the housing price bubble not have grown as big without the demand for the RMBS CDO CDS securities and the related superstructure?

Roger Gathmann said...

I suppose the question then would be: without the subprime stuff and the refis - which, remember, also overloaded american households with debt - how would Americans have pulled themselves out of the recession of 2000-2001? Here is a case where the Keynesian solution was tried in neo-liberal terms - through tax relief and the government's encouragement of gorging on debt for most households - and it finally led to a great collapse. When we replay the tape, then, we have to ask where the money was going to come from to keep up the life styles of households dealing with stagnant wages and unemployment. The recovery was weak, with a lot of the demand coming from the availability of borrowed money.

Almar said...

Unfortunately I can't find my copy, but the best account I've read of "over-lending", bubbles and crises is Kindleberger's book "Manias, Panics and Crashes".It's narrative and hasn't got any econometrics, but is nevertheless highly convincing.
A more formal analysis, is Jorda,Schularick and Taylor (2014).
My impression from these is that any large credit driven bubble can cause a crisis (unless policy reacts correctly), but that recently credit driven property bubbles have been particularly important.

Kaleberg said...

I think the overall cause of the current recession is the long term weakening of labor power in the face of technological and organizational trends. Labor is playing a losing game which can only be changed politically. This means that the economy is basically weak, much as it is in many third world countries, but now and then something happens that takes money from the wealthy and lets the typical worker get his or her mitts on some of it. Sometimes it is a world war or a cold war that allows the government to raise taxes and buy labor directly or indirectly. Sometimes is is a bubble fed by over-lending or over-investment. In any case, the increased flow of government or private money allows for economic growth, but this is rarely sustainable. Then the economy reverts to its usual state, though often labor is further weakened by the post-crash reforms.