People often argue that financial crises lead to slow recoveries. But I rarely see people argue the reverse; that slow recoveries cause financial crises.
It’s incredibly easy to make the reverse causation argument for the current eurozone crisis, or for the US financial crises during the Great Depression. But what about the US crisis of 2008? There certainly was significant financial stress before the recession began, or indeed even before economists were predicting a recession. So the reverse causality argument is more difficult to make for the US banking turmoil in 2007. But what about the much more severe crisis in late 2008? In that case I think we can easily make a reverse causation argument. Markets correctly began to realize that monetary policy (NGDP growth) was becoming too tight, and that a long slump was getting underway. This reduction in expected future NGDP led to lower current levels of AD, and also lower asset prices. This asset price decline greatly intensified the financial crisis in the fall of 2008.
Financial markets are forward-looking. As soon as they recognize that a long slump lies ahead, asset prices will crash. That will often (not always) cause a financial crisis. Ironically the cause of the crisis occurs after the effect, which is why it’s so often misdiagnosed.
PS. In one nanosecond a commenter will point out that the cause isn’t really coming after the effect. That’s getting too deep into metaphysics for me.
PPS. I see a number of liberal bloggers trying to defend Obama by arguing that recoveries from financial crises are usually slow. I don’t get it. Are they claiming recoveries are slow because of a lack of AD? Yes, but then the problem is insufficient monetary and fiscal stimulus, not financial turmoil. Are they claiming recovery is slow for structural reasons? Maybe, but I thought that was the conservative argument that liberals generally treated with contempt. Can someone help me here?