I recently suggested that if the economy is a car and monetary policy is the gas pedal, then perhaps the financial crisis was a flat tire. Keeping with the metaphor, we can ask.
1. Was the flat tire fixed by early 2009?
2. Was the flat tire an AD shock? Can monetary and fiscal expansion restore full employment?
I think that the mainstream view is “yes” to both questions. Of course, that depends on how one interprets the flat tire. If one interprets it as troubled banks and a high TED spread, then it was fixed. In that case, I am not sure how you would explain why the the macroeconomic problems lasted five years.
Perhaps it is more promising to say that the flat tire was not fixed by early 2009. Maybe the best one can say is that it was patched before even more was let out of it. Yes, the banks did not collapse, but financial confidence remained low, as reflected in tighter credit conditions for mortgage loans and business loans (can we really demonstrated the latter)?
I find it more promising still to suggest that the flat tire was a broader loss of confidence. Confidence in certain types of financial transactions fell. But it also fell in business in general. So older businesses rushed to let go of excess workers, and entrepreneurs did not rush to form new businesses.
So my inclination is to say “no” to both questions. Perhaps the air stopped running out of the tire, but it was not really fixed. Also, I do not think that it helps to view the economy as suffering from an AD shock. If the financial sector is not functioning properly, and the analogy is with having a nation-wide electrical power failure (as Larry Summers suggested in his “stagnation” talk), then that is more of supply-side issue. Moreover, if some businesses are shedding excess workers while other businesses are not hiring, then that is a PSST issue.
Possibly related, here is Timothy Taylor on Alvin Hansen. Taylor concludes,
I worry that the current U.S. economic policy agenda is all about fiscal and monetary policy, along with financial regulation and health insurance. I hear relatively little discussion focused directly on an agenda for creating a supportive environment for private domestic investment.
Carry the analogy a little further. In cars, especially race cars, trying to drive too far, too fast, or too long on a flat or partially flat tire will often cause it to explode, and do serious damage to the car. You can replace the tire, but that doesn’t repair whatever damage befell the car. And the driver may well not be confident for some time.
Hmm, to me the “flat tyre” analogy seems to suggest that the crisis was random, unexplainable and possibly exogenous (eg a spike in the road). Seems the crisis was a result of endogenous behaviour by people inside and outside the financial sector, and hence is better compared to the engine breaking down because it wasn’t set up correctly, or something.
Or we could just drop the car metaphor. I think the economy is too complex to warrant such a simple analogy.