This Morning's Must Read

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The Gjerstad and Smith article is a condensed version of a long (but even more theoretically and data-rich!) scholarly piece that will appear in Critical Review's special issue on the causes of the financial crisis, due out in June.

Also in that issue is John Taylor's famous paper blaming Greenspan, and much more.

To order a copy in advance, contact critical.rev@gmail.com.

Jeffrey Friedman
Editor, Critical Review

Two thoughts on the article:
As the article notes, housing prices started rising in the late 80's/early 90s. I wonder if part of the explanation was the phaseout of interest deductability and creation of HELOC. HELOC as a percent of income increased from less than 2% in 1991 to 8.7% in 2004. This allowed households to leverage.

House price-to-income is relevent only for first-time buyers.

A very insightful piece. And if you understand what they are talking about, including the parallels they see with the Great Depression, it ought to scare everyone half to death. At the same time, it should actually help us avoid such problems in the future. But only if (and I'm already starting to laugh at myself for even suggesting this) people in government pay them any attention at all.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

Is it snarky to point out that the people who were whacked in the dot com bubble pop were not nearly so "connected" as those who were going to get the shaft when this credit bubble popped?

Or, even simpler: That a bubble in the financial system caused more problems for the financial system than a bubble elsewhere does not seem like it needs a lot of detail in the explanation.

More to the point, the dot com bubble did not create or destroy real wealth, only redistributed it, while the housing/credit bubble did not create it but did consume it, it was what we lived off of the last several years. The debt hangover makes everything much worse. What created the Great Depression was the high degree of debt used to buy stocks. Margin is much more limited and regulated in the purchase of stocks now days, limiting the damage that can be created by a stock bubble, but not that created by a housing/credit bubble.

How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system?

Too, is it a fair comparison, $10 trillion versus $3 trillion and counting? Apples and oranges?

"They propose that the Depression was triggered by a mortgage meltdown, rather than by the stock market crash or a monetary contraction"

I would say that the mortgage meltdown and monetary contraction explanations for the GD aren't mutually exclusive. In fact in some sense they are complementary.

Noting that household wealth expectations were out of whack (through the accumulation of an unsustainable level of household consumption) is a very good point - but I don't think this dampens the importance of the monetary contraction story.

Fundamentally, the loss of expected household wealth will have real impacts that policy can't help to improve - while any associated contraction in the money supply will have real effect that policy can deal with.