How important was the financial crisis as a causal factor in the economic slump? Apparently, Brad DeLong and Dean Baker disagree. Baker wrote,
The $8 trillion in equity created by the housing bubble made homeowners feel wealthier. They consumed based on this wealth, believing that it would be there for them to draw on for their children’s education, their own retirement or for other needs.
When the bubble burst, homeowners cut back their consumption since this wealth no longer existed. However contrary to what you often read in the paper, consumption is not currently low, it is actually quite high when compared with any time except the years of the stock and housing bubbles.
in the absence of the financial crisis, the Federal Reserve’s lowering interest rates as consumption spending fell in response to the decline in home equity would have pushed down the value of the dollar and made further hikes in business investment a profitable proposition and so directed the additional household savings thus generated into even stronger booms in exports and business investment: in the absence of the financial crisis, what was in store for the U.S. was not a long, deep depression but, rather, a shallow recession plus a pronounced sectoral rotation.
Pointer from Mark Thoma. Conventional economics did not have a story of how stress in the financial sector could cause problems in the real economy. Even now, that view comes across as a just-so story. Baker argues that one does not need such a story, but DeLong says that we do need it.
I would note that if the financial crisis did not matter, then the bailouts, including interest payments on reserves, were simply transfers to bank shareholders. The more conventional view is that the bailouts prevented a horrible depression. So, the way I see it, the conventional view went from saying that the financial sector is nothing special to saying that you need to invoke specialness of the financial sector to explain how bad the recession was (Baker argues the opposite) and, moreover, the recession would have been even worse without the bailouts.
From a PSST perspective, I think that one must allow that it is possible that credit plays a big role in sustaining patterns of trade, and there may be something special about the financial sector. However, my own inclination is to see the financial sector as of 2007 as overgrown and to view the bailouts as making no contribution to the process of creating new patterns of specialization and trade.
Arnold,
I think you are on to something when you say, “From a PSST perspective, I think that one must allow that it is possible that credit plays a big role in sustaining patterns of trade, and there may be something special about the financial sector.”
Think about what happened in 2008 to commercial paper (CP), which major companies use all the time for payroll, utilities, rent, etc. It trades on highly liquid markets and at the top end functions as a key part of the structure of investment funds of all kinds, just below government securities in anchoring the safe end of investments.
Right after Lehman Brothers was sent to the guillotine in 2008, CP trading began to freeze up, producing the real risk that normal operations in perfectly sound enterprises would grind to a halt for want of this regular source of financing. This was one of the points of pressure that induced the huge reversal in policy leading up to the TARP. Harley Davidson and Verizon ended up accessing the Fed’s liquidity facilities. General Electric was a major participant. In other words it was the indication of a kind of catastrophic capital-market bank run that, in the judgment of policymakers, no Treasury Secretary or Federal Reserve Chairman could, in accordance with “lender of last resort” principle, fail to act decisively to stem.
“no Treasury Secretary or Federal Reserve Chairman could, in accordance with “lender of last resort” principle, fail to act decisively to stem.”
Here is my problem with this. They let Lehman go. Did they “lend freely at a punitive rate?” This (along with mark-to-market tightening) instantly changed any bailout uncertainty to at best extreme uncertainty in people’s mental accounting.
Today, 8 years into the housing downturn, mortgages are still well below their peak levels or even any reasonable long term trend level. And the imputed income from home ownership is very high – way outside any previous return relative to bonds. The housing market is way out of equilibrium and it’s because we hamstrung the mortgage market through procyclical regulation and by destroying home equity through disastrously tight monetary policy. It’s still not even close to an equilibrium.
By why then the financial crisis? Did the financial crisis cause itself? And when companies can’t make payments, isn’t it kind of hard to tell which part is financial crisis and which part is just can’t make the revenues?
To some degree, the financial centers are where the problems show up and are amplified. As Arnold says, the financial intermediaries agree to hold the short-term risky assets, so who else is going to lead the fall?
http://www.nytimes.com/2014/09/30/business/revisiting-the-lehman-brothers-bailout-that-never-was.html?_r=0
The government, through various options values etc., has enormous sway on the value of assets, stocks and flows (property rights delineation is probably their 2nd job). Just because nobody understands this doesn’t mean it doesn’t have real effects. The Lehman failure could have knock-on effects entirely divorced from any real impact from Lehman’s business itself simply due to re-calculation of the option values and probability decision trees under new information. The above article would seem to argue for rules (not to mention markets, e.g. NGDPLT) over discretion (and for better discretion guidelines and emergency protocols) particularly in crises if for no other reason (and there are many) than the bureaucrats are literally too distracted by one crisis (e.g. AIG) to properly tackle the next (e.g. Lehman).
Financial crisis was more effect than cause and no level of interest rates would have been sufficient to increase or even maintain investment given the lower bound. Bailouts made no (positive) contribution, but did stem the negative contribution of the run, limiting the financial crisis propagating it further and becoming a further cause.
DeLong implies that it was the financial crisis that pushed interest rates to the lower bound- when he says that otherwise The Fed could have stimulated business activity.