try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.
Pointer from Tyler Cowen. This argument broke out five years ago, and it is no closer to being settled. I might phrase it as the following multiple choice question:
a) the economic slump caused the financial crisis (the Sumnerian view, endorsed above)
b) the financial crisis caused the slump (the Reinhart-Rogoff view; also the mainstream consensus view).
c) both are symptoms of longer-term structural adjustment issues (I am willing to stand up for this view. Tyler Cowen also is sympathetic to it. Note that I do not wish in any way to be associated with Larry Summers’ view, which is that the structural issue is that we have too much saving relative to productive investments.)
d) both are symptoms of a dramatic loss of confidence. As people lose confidence in some forms of financial intermediation, intermediaries that are heavily weighted in those areas come to grief. Se see disruptions to patterns of trade that depend on those forms of intermediation. Moreover, as businesses lose confidence, particularly in their ability to access credit, they trim employment and hoard cash.
I want to emphasize that I see a reasonable case to be made for any of these views. There may be yet other points of view that I would find reasonable (although Summers’ “secular stagnation” is not one of them). In macroeconomics, if you think you have all the answers, then I cannot help you. I think that this is a field in which doubts are more defensible than certainties.
I am not even sure those are different answers. Bad lending and bad debt can be hidden by worse lending and worse debt, and this can continue to contribute to ‘income’ for as long as people believe it will continue and act as if it will continue, but even the most gullible reach the limits of their credulity, and the less gullible, more fearful, are quicker to jump. Once confronted with bad lending the cure is to tighten standards while relaxing rates rather than the opposite and eventually is when the opposite fails. Making up for a fall in ‘income’ from a fall in bad lending with a rise in good lending will always be difficult or bad lending wouldn’t have been resorted to in the first place, but making up for it in non debt fueled income is a near impossibility given current structures. Thus the structural adjustment away from debt fueled income and spending of the incapable and unqualified towards equity investment of the fearful but qualified. In that, they can’t lose what they never had for if they really had confidence they would have invested rather than lent. Lending is for those lacking in confidence other than in someone else to cover their losses, the reason collateral is so important to them. They realize just how risky investment really is so much it takes the certainty of loss to inspire them to accept it.
Not only is economics in a state of having more questions than answers, it would probably be best to always be trying to think how different partial explanations interact.
As in, structural issues built up, various shocks caused a small slump, which set off a serious financial crises, which caused a very large slump. Very many people lost varying degress of confidence along the way as this happened. Recovery from the loss of confidence, and the financial disorder, has been very slow.
In other words, varying amounts of a-d as well as other unlisted things, with size and importance changing over time.
Another way to conclude would be that the truth may combine elements of all 4 views, which may help explain why you find them all reasonable.
The first 2 seem particularly chicken and egg like. If households hadn’t pushed housing investment and consumption to unsustainable levels during boom, then the financial crisis may have been mild or not even registered as a crisis (real economy leads financial economy). On other hand, if mortgage borrowing and house prices hadn’t reached unsustainable levels, then we wouldn’t be suffering from the debt overhang that’s helped to prolong the slump (financial economy leads real economy).