Scott Sumner just replied to a piece I wrote back in April on the crash of 2008. Having lived through the crash - and lost a ton of money - it seems like a big part of the explanation has to be a sudden mood swing on the part of investors. Doesn't this violate the Efficient Markets Hypothesis? Not if these mood swings are unpredictable and subsequently affect the real economy.
Scott's not convinced:
My first observation is that it is very hard to know what the market is
thinking about, as the market is much smarter than any of us, and gets
"news" long before we do.
A second factor is policy credibility. It may be coincidence, but
right around the time of the three crashes there was a major loss of
trust in the government. In 1929 and 1937, investors lost confidence
in the President, and in early 2008 there was a loss of confidence in
Paulson and Bernanke's ability to manage the situation.
By early October I think the markets came to the conclusion that the
world economy was falling fast, and that the Fed would be unwilling or
unable (take your pick) to prevent a sharp downshift in NGDP growth.
The exact same thing occurred in October 1929 and October 1937.
My theory is that stocks don't have much independent effect on AD.
When expectations for NGDP growth do not fall sharply, then we don't
see a recession after a stock crash. We often see stocks fall before a
recession because the market often sees the recession looming ahead.
Scott goes on to point out problems with the panic story:
1. The law of large numbers. People don't independently all become nervous at the same time, for no reason.
2. I presume Bryan had some contagion effect in mind. But what
causes the contagion? Why does it occur in some stock declines and not
others? There is a lack of serial correlation in stock prices. When
prices have fallen for three straight days, there is still a roughly
50-50 chance they will rise on the 4th. So if the panic was internally
generated, if the beginning of the crash created panic, which led to a
bigger crash, then why wouldn't stocks that had fallen three straight
days be likely to fall on the 4th day?
3. If the panic was triggered by an external news event, why
wouldn't the crash have occurred on the day after some big event like
the Lehman failure. Instead it occurred in early October when there
was relatively little financial news. The only news I recall during
that time period were persistent reports of very bearish forecasts
about real growth and steeply falling commodity prices. Put the two
together and you have very bearish forecasts about NGDP growth. The
other news was a growing sense that Paulson and Bernanke were in over
their heads, but that fits in with my "monetary policy failure"