Brad DeLong has a post discussing a debate between Paul Krugman and Roger Farmer:
I find myself genuinely split here. When I look at the size of the housing bubble that triggered the Lesser Depression from which we are still suffering, it looks at least an order of magnitude too small to be a key cause. Spending on housing construction rose by 1%-age point of GDP for about three years–that is $500 billion. In 2008-9 real GDP fell relative to trend by 8%–that is $1.2 trillion–and has stayed down by what will by the end of this year be seven years–that is $8.5 trillion. And that is in the U.S. alone. There was a mispricing in financial markets. It lead to the excess expenditure of $500 billion of real physical assets–houses–that were not worth their societal resource cost. And each $1 of investment spending misallocated during the bubble has–so far–caused the creation of $17 of lost Okun gap.
(You can say that bad loans were far in excess of $500 billion. But most of the bad loans were not bad ex ante but only became bad ex post when the financial crisis, the crash, and the Lesser Depression came. You can say that low interest rates and easy credit led a great many who owned already-existing houses to take out loans that were ex ante bad. But that is offset by the fact that the excess houses built had value, just not $500 billion of value. I think those two factors more or less wash each other out. You can say that it was not the financial crisis but the destruction of $8 trillion of wealth revealed to be fictitious as house prices normalized that caused the Lesser Depression. But the creation of that $8 trillion of fictitious wealth had not caused a previous boom of like magnitude.)
To put it bluntly: Paul is wrong because the magnitude of the financial accelerator in this episode cries out for a model of multiple–or a continuous set of–equilibria. And so Roger seems to me to be more-or-less on the right track.
DeLong is certainly right that the housing bust is far too small, but it’s even worse than that. The vast majority of the housing bust occurred between January 2006 and April 2008, and RGDP actually rose during that period, while the unemployment rate stayed close to 5%. So it obviously wasn’t the housing bust. On the other hand you don’t need exotic theories like multiple equilibria—the Great Recession was caused by tight money. It’s that simple.
Or is it? Most economists think that explanation is crazy. They say interest rates were low and the Fed did QE. They dismiss the Bernanke/Sumner claim that interest rates and the money supply don’t show the stance of monetary policy. Almost no one believes the Bernanke/Sumner claim that NGDP growth and/or inflation are the right way to evaluate the stance of policy. Heck, even Bernanke no longer believes it.
And even if I convinced them that money was tight they’d ask what caused the tight money, or make philosophically unsupportable distinctions between “errors of omission” and “errors of commission.”
In previous blog posts I’ve pointed out that it’s always been this way. If in 1932 you had said that tight money caused the Great Depression, most people would have thought you were crazy. Today that’s the conventional wisdom. If in the 1970s you’d claimed that easy money caused the Great Inflation, almost everyone except a few monetarists would have said you were crazy. Now that’s the conventional wisdom. Even the Fed now thinks that it caused the Great Depression and the Great Inflation. (Bernanke said, “We did it.”)
The problem is that central banks tend to follow the conventional wisdom of economists. So when central banks screw up, the conventional wisdom of economists will never blame the central bank (at the time); that would be like blaming themselves. They’ll invent some ad hoc theory about mysterious “shocks.”
The other night at dinner my wife told me that the Chinese sometimes say, “If you cannot see the true shape of Lu Mountain, it’s because you are standing on Lu Mountain.”
In modern conventional macro, most people look at monetary policy from an interest rate perspective. That means they are part of the problem. They are looking for causes of the Great Recession, not understanding that they (or more precisely their mode of thinking) are the cause.
Only the small number of economists who observed Mount Lu from other peaks, such as Mount Monetarism or Mount NGDP Expectations, clearly saw the role of central bank policy. People like Robert Hetzel, David Beckworth, Tim Congdon, etc.
PS. Before anyone mentions the zero bound, consider two things:
1. The US was not at the zero bound between December 2007 and December 2008 when the bulk of the NGDP collapse occurred, using monthly NGDP estimates.
2. Do you personally support having the Fed use a policy instrument that freezes up exactly when you need it most desperately? Or might the problem be that they’ve chosen the wrong instrument?
PPS. Yes, not everyone on Mount Monetarism saw the problem, but as far as I know no one on Mount Interest Rate got it right. Perhaps Mount Interest Rate is Lu Mountain.
PPPS. To his credit, Brad DeLong thought the Fed should have promised to return NGDP to the old trend line. If they’d made that promise there would have been no Great Recession, just a little recession and some stagflation.