Mundell as Sumnerian?

But by summer 2008, spooked by rising inflation...

It's very strange, but in all the analysis of the cause of recession what near everybody ignores is the very thing everybody was yelping about at the time -- oil zooming up to $150 a barrel.

Today I see only Jim Hamilton arguing that it had a real and signifcant effect on the course the economy took -- for everyone else it seems to be "down the memory hole".

But remember how hysterical about it everyone was then? With all the screaming about market manipulation, and argument about whether or not there was a dangerous bubble, and speculators driving up the the price (of oil, not housing).

That was less than two years ago. All forgotten for its economic impact now.

But should it be?

Mundell's Nobel Lecture from 99 is great.

http://nobelprize.org/nobel_prizes/economics/laureates/1999/mundell-lecture.pdf

Coming across his views recently, I wondered why he isn't considered a giant on the right, considering that he's the father of supply side economics. Maybe it's because he's Canadian, or maybe AK's explanation is more likely.

Jim Glass - No, and I think that's consistent with Sumner's story. Rising commodity prices, including oil, were what make it look (to the fed) as if there was a risk of inflation. And there might actually have been - there's no fundamental reason why you can't need more liquidity to keep the supply and demand for credit in equilibrium as banks step down their lending, and also have that new money push the demand for commodities still higher, driving consumer price inflation.

In retrospect it seems fairly clear that high food and gasoline prices, tight credit and falling household wealth combined to push down spending in the last half of 2008.

My impression of what happened is that the financial markets started to be vaguely aware that many subprime mortgages were dubious in early 2007, and figured it out with a vengeance around August 1, 2007.

To prevent a recession, the Fed (and perhaps other central banks) responded with a flood of money, much of which went into bidding up the price of food and, especially, oil (to $147 per share). That turned into higher gasoline prices (I paid $87 to fill up my minivan in June 2008), which in turn absolutely killed housing prices in the exurbs of the Sand States because they are dependent upon long commutes to jobs.

So many subprime mortgages were held upon exurban homes that the rapid decline in home prices in 2008 in places like SoCal's Inland Empire drove many mortgage holders underwater, exposing the fact that many had no way to ever pay off their mortgages other than flipping them for a higher price. But, now, nobody wanted to own a home with a long commute. So that wiped out mortgage-based securities, which set off the Panic of September-October 2008 as financial institutions floundered about trying to figure out which of their potential counterparties would remain in business.

In summary, the Fed's inflation of 2007 to prevent a subprime-driven recession just caused a bigger one in 2008.

Am I right?

Not just oil... the entire commodities market was extremely expensive.

Right, eggs cost a fortune at the supermarket in 2008.

But the price of gas was the dealbreaker, because it was negatively correlated with the perceived value of an exurban home in places like Hemet, CA, 88 miles east of downtown LA. If it was going to cost a fortune to commute from Hemet to downtown, the surely the price of a home in Hemet had to come down from, say, $400k to $200k, leaving everybody who had bought in the last five years underwater.

So, by trying to prop up subprimes, they ended up throttling subprimes. Way to go, Fed!

in my opinion oil was a problem mainly because the supply was external and not internal, making it harder to control. raising rates to appreciate the dollar worked, but killed the rest as a result.
and when the economy was killed, oil was not needed as much. talking about a toxic medicine.

@ Steve Sailer:

"In summary, the Fed's inflation of 2007 to prevent a subprime-driven recession just caused a bigger one in 2008." Only because the Fed lost its nerve. If it had kept on pumping up the money supply through the end of 2008, most of the crisis would have been avoided.

"Only because the Fed lost its nerve. If it had kept on pumping up the money supply through the end of 2008, most of the crisis would have been avoided."

But that would have driven the price of oil to $300/bl., which would have killed the price of homes not only in the exurbs, but also in the suburbs, driving even more mortgage-holders underwater.

Can you really inflate your way out of a Bubble?

"Can you really inflate your way out of a Bubble?" Better than trying to *deflate* your way out!

On another topic: when Arnold Kling was in graduate school, Mundell was in his mid-40s. Isn't that a bit young for senile dementia?