Arnold Kling

Did the Financial Crisis Matter?

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Fannie and Freddie and Friends... Working: The Graphic No...

Dean Baker says no.


Spain is noteworthy because it now has an unemployment rate of more than 19%, the highest rate in any of the wealthy countries. Spain did not have a financial crisis. In fact, its well-regulated financial system is often held up as model for the United States.

Spain did have a horrific housing bubble. As a result, the share of construction in the economy rose from less than 8% of GDP at the end of the 90s to 12.3% in 2007

If Baker is correct, then the financial crisis was not the real problem. Which means that TARP, the bailouts, and turning the Fed into a piggy bank were not the solution.

Thanks to Mark Thoma for the pointer.


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COMMENTS (17 to date)
John Thacker writes:

And noting that plenty of places around the world had a housing bubble-- but not all states in the US-- it's reasonable to then at least take a good, hard look at the problems with zoning and land-use management, as recommended by Ed Glaeser and others.

Richard A. writes:

Our economy got use to a growth rate in nominal GDP of about 5%/year. The Fed allowed the growth rate of GDP to shift down to about 0%. Something had to give and that's real GDP in the short run. In other words, the Fed screwed up.

Why did the Fed screw up? I can only guess.

Scott Sumner writes:

He's right that the financial crisis wasn't the key problem. The problem was falling NGDP. The ECB reduced Eurozone NGDP even more sharply than the Fed reduced US NGDP. That created a severe recession everywhere in the Eurozone. Spain suffered even more than average, for many of the same reasons that Florida, Arizona, Nevada and California suffered more than average in our recession. Even when AD is falling everyone, sectoral shocks are still important at the local level.

And Spain is also hurt by their dual labor market, which makes their unemployment higher on average than the rest of the Eurozone.

fundamentalist writes:

The Minneapolis fed agreed last year when it came out with a paper claming that no systemic crisis existed. It said that a few big investment banks were in trouble, but nothing more.

Lee Kelly writes:

The problem, in my opinion, was, and still is, an excess demand for money (i.e. a deficient supply of money); the financial crisis was a product of monetary disequilibrium--both its cause and aftermath. Nothing else makes good sense (to me--an internally recognised authority on macroeconomics, banking, and money).

Pietro Poggi-Corradini writes:

Also Canada during the Great Depression had no bank failures but still suffered a nasty crisis. So how important (different) is the banking system, really?

Philo writes:

Baker wrote: "There is no easy mechanism to replace more than $1tn in lost demand." I think he's talking about *nominal* demand, in which case the "easy mechanism" is obvious: it's the mechanism of inflationary monetary policy.

ray l love writes:

Since this seems to be an open forum on the cause of the current downturn, here is my $o.o2 worth:

When money is earned, saved, and then invested, asset values remain tied to incomes, of course. So 'bubbles' are the result of too much of the wrong type of investment. Too much leverage, foreign in-flows, and securitizing etc., and too much capital chasing too little value. Growth in the recent episode and for decades has been too reliant on debt expansion, and not reliant enough on the expanding value of human capital. Hence, we have wealth distribution imbalances and deleveraging on a global scale. This has caused weak global aggregate demand for goods as well as loans.

The_Orlonater writes:

He's also implying that markets are bad at handling risk, which is false. Secondly, the U.S. government was hiding the risk associated with certain financial instruments so which is why many financial institutions have had great losses, and perhaps will have even greater losses in the future once the Federal Reserve sells off what assets it bought at an uncertain, most likely an above market price. Thirdly, he assumes that these regulations have done no unseen damaging effects by preventing certain investments and utilization of resources to be made.

Ozornik writes:

So, it is March 2010, and you guys still don't have a clear-cut answer?
Some science you represent...

Elvin writes:

I'd like to see some stats on overall leverage. In the US, certainly the household sector leveraged itself through housing and some through credit cards. The financial sector became more leveraged as well. My guess is that Spain had similar levels of household leverage, even though its banks may have been OK.

We've been through this debate before. Sumner says the Fed could have prevented it; I feel otherwise. The oil prices and slumping employment of early 2008 clobbered households and businesses enough that they were pulling back no matter what. Yes, theoretically the Fed could have somehow convinced the public that inflation would be 5%. Theorectically, I could play centerfield for the Yankees. Convincing household that their incomes would be rising 5% in nominal terms as housing prices slumped, equity prices dropped, and unemployment was rising would have been the greatest sales job in history.

Troy Camplin writes:

What were the interest rates in Spain? Were they kept artificially low (as I suspect they were)? In states where there was a housing bubble, did state regulations encourage state banks to follow the Fed's downward pressure on interest rates? I know that here in Texas there are few state regulations on banks. So Texas has many banks, none of them very large (as I would predict in a low-regulation environment). In the states where there was a bubble, were the governments of those states more likely to encourage/pressure banks to make subprime loans? Do we see patterns of (artificially) low interest rates correlating with patterns of housing bubbles? I suspect we would, because low interest rates are a market signal that one should take more risks. That is what a bubble is, after all: more and more people taking more and more risks, until the risky ventures stop paying off and start falling apart.

Nick writes:

Troy Camplin,


What were the interest rates in Spain? Were they kept artificially low (as I suspect they were)?

John Taylor seems to think so you can find his paper on the subject by googling "John Taylor The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong"

He also discusses it in the Econtalk archives.

ray l love writes:

Troy,

You are making the mistake of assuming that interest rates are arbitrary matters of monetary policy. Interest rates though are also a matter of supply and demand in regards to liquidity.

I agree with you though insofar as any viable comparison to Spain needing to consider interest rates. But I also think leverage ratios and foreign in-flows would be just as important to establish what is "artificial", or what is in line with the supply of capital. Such a comparison though would be difficult because of the Dollar's role as a reserve currency, [consumer of last resort etc.].

Craig Bardo writes:

TBTF is a flawed premise failing in real time before our eyes. One needn't join conspiracy theorists who surmise that Paulson bailed out his former colleagues via TARP & their inclusion of AIG, which is obviously not a bank to see the mercantilist virus in our increasingly political economy. Reflexive calls for increased regulation shouldn't be so easily yielded to before thoroughly examining the role regulation played in the disturbance. Reg g, mark to market, the government role in deciding which firms can evaluate the creditworthiness of regulatory capital as a proxy for investors, not to mention FNMA & FHLMC oversight are just a few that come to mind. Anecdotally, compare the regulation of insurance companies to banks. How many banks have failed versus insurance companies? Just sayin'!

Ocean writes:

Maybe Spain just didn't go through Schumpeter's "Creative Destruction", as the US did. Its versions of Lehman Brothers and Bear Sterns (and others still around in the US) are still making over-leveraged risky investments, instead of being replaced by healthier alternatives.

Troy Camplin writes:

I wish interest rates really were a matter of supply and demand. But they are not. Here in the U.S. the Fed regulates the interest rate banks use to lend money to each other. The Fed and various regulations also put a lot of downward pressure on interest rates in the U.S., keeping them artificially low through that pressure. This isn't the free market -- it's the distorted information of a highly regulated market. Which is one of the main things that caused the problems we are now in.

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