Arnold Kling  

Narrating the Financial Crisis

The Wisdom of Steve Miller... The Case for Trial and Error...

Scott Sumner raises some challenging points.

But the link between the housing bubble and the severe financial panic is much weaker than people realize. And the link between the severe financial panic and high unemployment in 2011 is almost nonexistent.

Read the whole thing. It is an important post.

Paul Krugman writes,

What's holding the economy back despite the easing of the financial crisis per se, the evidence suggests, is the overhang of household debt.

The original narrative of the financial crisis was that the run on the shadow banking system caused risk spreads to rise tremendously. Remember all the talk about using the TED spread (Treasury vs. Eurodollar) as the "thermometer" showing the "fever" from which the financial system was suffering?

The link between these risk spreads and the decline in the real economy typically was not spelled out (although Mark Zandi and Alan Blinder claimed that it was a big part of their modeling exercise that showed that TARP saved us all). Most economists just thought it was intuitively clear that these higher risk spreads killed the economy.

Krugman now wants to tell a story based on household balanced sheets. So does Vernon Smith (see his work with Steven Gerstad or their paper). Maybe so does David Leonhart.

If you look at the financial "thermometers," the crisis exploded in the summer of 2008 and was over by early 2009. If you look at monthly GDP (see Sumner's post), the problem began about April of 2008, the worst was over by early 2009, and real GDP finally turned around in the middle of 2009. To give Sumner his due, I think it is really, really hard to tell a story in which the financial fever affects the real economy with a lag that is very short, or even negative.

Of course I prefer to look at the ratio of employment to population. Relative to monthly GDP, it seems to me that this ratio started falling sooner and kept falling longer.

I think the point to keep in mind is that the narrative for the crisis could really change as the dust settles. Again, I urge you read Sumner's entire post.

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CATEGORIES: Macroeconomics

COMMENTS (16 to date)
Scott Sumner writes:

Thanks for the recommendation. I might add that my work on the Great Depression convinced me that great problems have multiple causes. If a single factor could produce great disasters, we'd have lots more great disasters than we do. My narrative is intended to add an overlooked set of causal factors, not to rule out explanations developed by others.

One big problem most macroeconomists haven't really confronted is to distinguish between the direct effect of financial turmoil on RGDP, and the indirect effect of financial turmoil throwing monetary policy off course, reducing NGDP, and then that reduces RGDP through a conventional sticky wage/price mechanism. It seems likely that both transmission mechanisms were at work, but how important was each? My hunch is that the indirect effect is stronger.

Elvin writes:

I glanced through all these links and I don't think I see any mention of oil.

If you take the rule of thumb that each $10 increase in the price of a barrel of oil causes a 0.25% short run decrease in real GDP, then the rise from $70/barrel in the summer of 2007 to $140/barrel in the summer of 2008 should have dropped real GDP by 1.75%. With a weak economy (housing construction--a major driver of growth in the mid-2000s--started contracting in mid-2006) and loss of the home equity ATM machine, the consumer hit a wall in July 2008. Given their balance sheets and employment prospects, households had no choice but to deleverage. Unfortunately, it came at a bad time for the financial sector; as it had to deleverage as well.

This left the US government and Federal Reserve as the agents to lever up to help to contain a collapse.

Otto Maddox writes:

Looks like Leonhart repeats the canard about Hoover cutting spending:

"If governments stop spending at the same time that consumers do, the economy can enter a vicious cycle, as it did in Hoover’s day."

Chris Koresko writes:

Scott Sumner: It's awkward to try to criticize the ideas of someone who is obviously more deeply knowledgeable than myself, but I am moved to do so by what amounts to a gut feeling that this story is focused too much on the measurable quantities (NGDP, RGDP, etc) at the expense of poorly-measured, but potentially more important, factors.

My sense is that we are suffering from a series of related policy blunders, all of which were efforts to expand government control over the economy.

The push to expand homeownership was one of these. Never mind the rate of housing starts per unit population; what matters for this argument is the amount of wealth flowing into the housing market, and the degree to which that wealth was well-invested. Policy changes resulted in a lot of people living in homes they couldn't really afford, and because their loans were non-recourse, the error was corrected at the expense of the lenders, and ultimately of the financial system.

Then there was a federal push to keep delinquent borrowers in their homes via "loan modifications", which tended to involve government arm-twisting of creditors into abandoning some of their property rights. Something similar appears to have happened with the big auto bailouts, with the President himself publicly scolding Chrysler's secured creditors (whom he referred to as 'speculators') for demanding that they be paid their due according to the law.

The legal security of property rights is acknowledged by the Washington Consensus as a key factor in economic growth for developing countries. Would it be surprising if a pattern of violations of it by Washington itself had an adverse impact on the U.S.?

Then there was a set of policies which drove up the cost of labor, including a rather large increase in the minimum wage, regulatory changes to make it easier for employees to sue their employers, and the Affordable Care Act which is the "devil we don't know" because a lot of it is implemented in as-yet unwritten regulations. Since these policies (I think... correct me if I'm wrong) raise the cost of labor by an amount which is larger as a percentage of the total for lower-wage workers, their effect is to preferentially increase unemployment at the low-wage, low-education end of the labor market. This is the pattern we have in this recession.

On top of that there is a complex new set of financial regulations (I'm talking mostly about Dodd-Frank here) for which apparently no one in the government has attempted to assess the cost to business (according to Congressional testimony... sorry, my memory is vague as to who gave it). And it's apparently created a whole new set of offices with new regulatory powers, while apparently making no effort to rein in Fannie & Freddie. The latter omission makes it look like the government is content to allow those institutions to continue operating more or less as they did when they helped cause the housing crash; in fact, the President himself has called for a strengthening of the CRA.

At the same time the executive branch has started unilaterally granting Affordable Care Act wavers to specific organizations, despite (as I understand it) having no legal authority in the Act to do so. And then it turns out that a substantial percentage of those waivers went to businesses in the district of Nancy Pelosi, the former House Speaker who was instrumental in getting the Act passed, and another large fraction to labor unions who also pushed for it.

Meanwhile the federal government has been throwing around trillions of dollars based on planning which appears haphazard at best. There was most of a trillion in TARP, which was billed (if memory serves) as a way to rescue "too big to fail" financial institutions by buying toxic assets, but turned into a kind of slush fund. Some of that was lent to banks that didn't need the money and repaid it. The TARP law required that the repaid funds go back to the treasury, but some of them got spent anyway... correct?

Then there is the Treasury, which has been making trillion-dollar-class moves with euphemistic names (“quantitative easing”). Almost no one outside Treasury seems to understand what is going on, and it's worrisome.

And of course there is the 'stimulus', which passed on an almost purely partisan vote and was billed as a means to kick off 'shovel-ready' projects across the country, but turned out to be mostly short-term tax cuts and grants to keep state governments from having to make budget cuts for a year or two. And multi-billion dollar projects that were in no way 'shovel-ready', but would take years or decades to complete. And there were scandals associated with it, involving jobs 'created or saved' in non-existent zip codes and the like. In the end, the 'stimulus' money spent on new construction projects in the first couple of years was what, a few percent?

And throughout all of this was the prospect of a big income tax increase coming with the expiration of the Bush-era cuts, initially in 2010 and now delayed a couple of years... maybe.

The President has been all over the place on taxes, campaigning with the promise of a middle-class tax cut and promises that there would be no tax hikes of any kind. At times he has advocated a reduction in the corporate tax rate. Lately he's refusing to accept any deal on the debt limit that doesn't include a tax increase, and has been railing against the rule changes for taxation of corporate jets which were put into place by the 'stimulus' law.

On top of all this, it appears to be U.S. policy to choke off its own energy supply. We've seen the ban on drilling in the Gulf that persists despite the order of a federal judge; new moves that will force the closure of many coal-fired power plants; an expressed desire on the part of our Energy secretary to see gasoline prices reach European levels; and the beginnings of a regulatory regime for carbon dioxide, despite the refusal of Congress to authorize it.

Meanwhile the federal debt is growing at an alarming rate, and it's not hard to see that we are in for some combination of massive spending cuts, massive tax increases, and federal default, in the near future... years, not decades. The politicians are disunited and intransigent. Apparently the only detailed plans to deal with this, like Simpson-Bowles and Ryan, are off the table.

So the bottom line is that federal economic policy is in shambles, growing less coherent and more destructive as the government itself grows larger and more powerful. And the people who matter recognize this. Surveys show very little optimism on the part of the entrepreneurs who produce essentially all net U.S. job creation. A recent study (by Tyler Cowen if memory serves) shows pretty conclusively that employment depends on private (not government) investment spending.

So I think that looking at NGDP and monetary policy at this point is not going to give you a good sense of what's happening. The real drivers are not easily quantified, and are not the kind of things that show up in a macro textbook model. It's no surprise to me that the modelers are being repeatedly surprised by how poorly the economy is doing lately.

PS: I just previewed this and realized it's far longer than anything I'd normally write (or read!) in a blog comment. Webmistress, if you decide to delete this for that reason I understand.

GlibFighter writes:

I urge you to read:

Pete writes:

If too many homes being built was not a major contributor to unemployment, why would unemployment in the construction sector have hovered around 25-30% during the crisis and still be above 20% (as of July 2011)?

That doesn't seem to square with Scott's thesis.

Clint Kennedy writes:

I think that Paul is right. There was a tremendous loss of equity in homes. Consumers lost most of their asset values here. And the relationship between this and that. There needs to be every possible support for households to regain asset values. In stead of becoming more tight and requiring more capital, banks should ease on less risky loans.

Thomas DeMeo writes:

Pre-crisis, consumers spending using home equity did drive a tremendous amount of economic activity, and the vast majority of that activity is gone.

The nuance here is that much of that money went into home improvement. The bubble wasn't so much in inflated home prices as it was inflated home investment. To use a car analogy, we didn't overpay for a Chevy, we bought a BMW and can't afford it.

Yancey Ward writes:

Chris Koresko,

I took the liberty of quoting your entire comment over on Scott Sumner's blog. I hope you don't mind, but I am not sure Sumner would see it otherwise, and I thought it was on point and deserved a wider read than it might get here.

Chris Koresko writes:

Yancey Ward: I took the liberty of quoting your entire comment over on Scott Sumner's blog.

I'm honored. Thank you.

Steve Sailer writes:

Scott Sumner writes:

"In the history books it says the 1929 stock market crash triggered the Depression. After an nearly identical crash in 1987 had zero effect on GDP, we learned that was false."

I don't think that's a terribly persuasive way to reason about historical causality.

Consider an analogy: the history books say that the assassination of the Archduke in 1914 led to WWI. But the assassination of JFK or RFK or Sadat or Rabin or the various Gandhis didn't lead to WWIII, so we learned that was false.

No, the assassination of Franz Ferdinand led to WWI. It didn't necessarily have to and it wasn't the sole cause, but, as history turned out, it was the direct cause.

Similarly, the bombing of Pearl Harbor led to American entry into WWII, including the fighting in North Africa, Italy, France, and Germany. That's how the chain of causality played out in our world. It didn't have to happen that way and Pearl Harbor isn't the only cause but it's the direct cause.

U.S. decisionmakers responded to Pearl Harbor pretty reasonably. They understood it wasn't the entire cause of our involvement in the war, but they took seriously the lesson that the U.S. was vulnerable to sneak attack and subsequently invested heavily in warning and retaliation systems, which succeeded in deterring another sizable sneak attack on America until 2001. That's not bad.

Hugh writes:

If Paul Krugman thinks that household debt is the issue, how can he also think that more government spending is needed?

Extra government spending would help only to the (almost nil) extent that it relieves the debt burden of families. In other words it won't help at all.

Shayne Cook writes:

For Scot Sumner's consideration ...

First, I concur with your general thesis, most notably the lack of understanding of the linkage between the housing crisis, financial crisis and current non-robust NGDP and employment growth. I also concur with your statement above that problems as dynamic as these do not have a single cause - they have at their foundation a variety of contributing/supporting factors.

I would suggest a re-think on your part regards relying on your data on housing starts as an explanatory variable to housing finance during the 2002-2007 period. You state, "The private banking system and the GSEs both played a major role in causing too much housing to be built in the mid-2000s." But you note that housing starts during that period were not historically remarkable. I'd recommend re-stating that to, "The private banking system and the GSEs both played a major role in causing too much housing to be financed in the mid-2000s.", and consider the implications of that to your thesis. I merely gathered from your article that you may be over-relying on housing starts data as a reliable proxy for housing market financial flows. Housing related financial flows became completely de-coupled from the actual (market sustainable) housing market - most notably during and after 2004.

Shayne Cook writes:

To Scott Sumner ...

My sincere apologies for mis-spelling your name (Scot), above.

Mr. Econotarian writes:

If unemployment was back to 5% no one would care.

We have to ask the question about why unemployment continues to be so high.

I suspect it is due to a combination of changing structures of the economy combined with labor regulatory changes that have been piling up over the last 20 years.

For example, a fast food establishment I frequent has replaced at least one worker with an ordering machine. I hate to say it, but I prefer the ordering machine...

Charles R. Williams writes:

The link between the bubble and the panic may be weak and the link between the panic and the recession may be non-existent but it doesn't follow at all that there is no link between the bursting of the bubble and the recession. The linkage is through household net worth. And since macroeconomic policy cannot create wealth, goosing NGDP will flow immediately into the price level (monetary interventions) or into unsustainable output of uneconomic goods (gov't spending).

People are not consuming because they must save. They are accumulating cash because investment opportunities are limited. The way forward is for individuals to create investment opportunities. This takes time and most importantly an economic-political climate that fosters investment. The latter is the missing policy ingredient.

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