In Greg Ip’s new book, Foolproof, he writes,
Frederic Mishkin, an expert on banking who had studied the Great Depression, examined what would happen if housing prices fell 20 percent. The Fed, he argued in a lengthy presentation to other central bankers, would lower interest rates quite quickly, the economy would shrink only 0.5 percent, and unemployment would barely rise.
I have not yet read Bernanke’s new book, but I gather that he thinks that without the bailouts the economy was headed toward another Great Depression. So my point is that there is quite a gap between what Mishkin thought would happen if housing prices fell and what Bernanke was afraid was going to happen. Some possibilities.
1. Mishkin actually was right. The economy easily could have withstood the housing price crash. The problem must have been something else. (Scott Sumner would say that it was tight money.)
2. Mishkin was working with a simplistic model of the economy, which did not include the fragility of the financial sector or the feedback from loss of confidence in banks to the rest of the economy. There are two variations on this view
a) the bailouts helped, just as Bernanke says they did.
b) the bailouts made no macroeconomic difference. They simply served to redistribute losses away from the some of the stakeholders in the bailed out firms.
3. Mishkin actually was right. The economy would have recovered quickly with only a small recession. However, Bernanke and other policy makers did the wrong thing and turned what would have been a short-term crisis and the failure of a few firms into a long, drawn-out period of slow growth.
I think that (2a) is the most generally accepted view. My own view is 2b. I could also make a case for (3). Note that in the Great Depression, both Hoover and Roosevelt thought that destructive competition was a major problem. Both tried to discourage businesses from competing, Hoover through exhortation and Roosevelt through the National Industrial Recovery Act. In hindsight, reducing competition was a counterproductive idea. Perhaps in hindsight TARP and the other bailouts will not look so good, either.
By the way, I can offer a lot of praise for Ip’s economic judgment. However, I think I will end up putting Foolproof in the “very good but could have been even better if. . .” category.
What about 2c. The Bailouts Hurt.
First, they hurt in the sense of moral hazard of implicit bailouts. Then they proceed in ad hoc fashion creating mass confusion. Then the market had to recalculate values based on nebulous standards of what constituted bailout-worthy firms and what that meant for the values of their assets. Perhaps this (and tight money would exacerbate this problem) threw the pricing system into chaos as scarce flows of money scrambled not for stocks of intrinsic value, but for stocks of political bailout value. Assuming that bailing out individual firms here and there also bails out the economy is just an assumption.
1.5: Falling house prices were one piece of a vicious loop that inevitably follows a period of unsustainable spending (on home construction certainly but in other areas as well) relative to incomes.
I can see that you’re simplifying but instead of financial fragility, confidence, tight money, etc., it may just be that real-economy spending was unsustainable and needed to correct, with house prices being part of that dynamic. After all, activity remained in the doldrums for a long period, but that doesn’t necessarily put the blame on the bailouts per your #3 – you could also look at that as evidence that the economy ran too hot for too long and needed to slow down.
House price expectations help to explain why activity became unsustainable, but so do expectations for the business cycle (Great Moderation), expectations for default rates, expectations for stock prices, expectations for monetary policy (the Greenspan/Bernanke put), etc.
Bernanke seemed to follow Mishkin early (“subprime contained”) before coming to a different conclusion. There is no clear demarcation between 2a and 2b though the extreme version of 2b is inconsistent with PSST since it assumes re-establishing new patterns is costless.
Not true. The cost was baked in the cake. It has always been exceedingly weird that the establishment has been able to run this con game that the great recession was a successful soft landing when it was a dumpster fire.
Like no other banks would have failed without support? Begs credulity. Those institutions that fail do require re establishment of new patterns, which is just what failure means. Housing fall embedded yes, banks and institutions doing many other things as well no.
I don’t think Arnold places as much emphasis on the unsustainable patterns in his ideas of PSST because he is more concerned with economies than recessions.
But I don’t see anything in what happened that contradicts PSST. In fact, I think PSST is the best paradigm for how to understand it. People assume that banks were saved. Well, we still had a near depression. So how much did that really help? The next assumption is that we would have had a full-blown depression. Again, it’s another assumption. But neither of those assumptions address how the system got so far down an unsustainable path that required some form of correction and why we haven’t yet (and may never…ever) re-establish what the macro mainstreamers think of as “trend.”