Slow recoveries cause financial crises

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?



53 Responses to “Slow recoveries cause financial crises”

  1. Gravatar of Arthur Arthur
    19. October 2012 at 10:34

    I think people’s reasoning is something like this:

    Financial crisis somehow makes the nominal stickiness worse. So the fall in AD makes the RGDP drop more than otherwise it would. But the recovery is faster then normal, because solving the nominal stickiness yields more benefits.

    Or maybe financial crisis cause a big drop in velocity, causing a big AD drop.

    Anyway it’s clear that more AD could solve the problem.

    Maybe the thing is in this kind of crisis the FED (Or the feds) need to do more than usually and they don’t because of policy restrictions.

  2. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    19. October 2012 at 10:35

    ‘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.’

    Nor do Bordo, Haubrich and John Taylor;

    Aside from the unnecessary political rhetoric and ad hominems, the basic difference between my research with Joseph Haubrich on U.S. recoveries and that of Carmen Reinhart and Ken Rogoff is over the methodology of defining a recovery. Reinhart and Rogoff focus on the behavior of the level of real per capita GDP from the peak preceding the financial crisis to the point in the succeeding recovery at which the earlier peak level of real per capita GDP is reached. We look at what is called the bounce back, the pace of recovery from the trough of the business cycle.

    We find that deep recessions accompanied by financial crises bounce back faster than recessions which do not have financial crises. These results are even stronger when we focus on what Reinhart and Rogoff call systemic crises, like 1893 and 1907. The recent recession and financial crisis is a major exception to this pattern. The recovery remains tepid after three years.

    Reinhart and Rogoff’s methodology combines the downturn with the recovery. Using our data but following their approach one would get the same results as they do, that recessions with financial crises have slow recoveries as I show in my Wall Street Journal op ed. Their use of real per capita GDP rather than just real GDP would not make any difference to our results. Thus comparing their methodology with ours is like comparing apples with oranges. Our approach focuses directly on the question– are recoveries after recessions with financial crises associated with slower or faster than average recoveries. Their approach answers a different question than we ask.

  3. Gravatar of Kevin Donoghue Kevin Donoghue
    19. October 2012 at 10:36

    “I don’t get it.”

    I noted in another thread that you don’t seem to read the posts you link to, so it’s hard to help you really. Basically the problem is, as you suggest, insufficient monetary and fiscal stimulus. Kalecki started the discussion about the political reasons for that.

  4. Gravatar of Jon Rodney Jon Rodney
    19. October 2012 at 10:39

    I think the defense of Obama’s record goes something like this:

    1) In the absence of NGDP targeting or a similar monetary regime, and in the absence of strong and sustained fiscal stimulus, financial crises tend to have a slower recovery than otherwise.

    2) The Obama recovery is above average when compared to other financial crises, and given that monetary policy was too tight, he can reasonably claim that his fiscal policies contributed to that.

    3) Conservative criticisms that deeper recessions should be followed by stronger recoveries are unreasonable, particularly when they only look at the rate of growth from the trough. Comparing the 1980 recession to the recent financial crisis or the great depression is not an apples-to-apples comparison.

    I also think the liberal bloggers you refer to would happily criticize Obama for not pushing for more monetary and/or fiscal stimulus.

  5. Gravatar of Andy Harless Andy Harless
    19. October 2012 at 10:54

    The honest liberal argument is that the zero lower bound (like other limitations on monetary policy, such as a gold standard) makes policy more difficult — in the sense that both liberals and conservatives are less likely to do the right thing under those circumstances. I don’t think there is an honest way to say Obama has been a success economically unless you’re grading on a curve. But when you’re choosing between two candidates, presumably you should be grading on a curve: no particular reason to think Romney would have succeeded where Obama has failed, and if anything Romney’s rhetoric suggests he’s more hawkish than Obama. Graded on a curve, Obama does pretty well: he does better than others have done under similar circumstances, so maybe he gets an A- or a B+. Depending on how you fit Roosevelt onto the curve, possibly just a B. My view is that Obama still gets at least a B+ on the curve despite Roosevelt. Roosevelt faced an obvious and easily removable constraint on monetary policy, which he proceeded to remove (as he clearly had the power to do). For Obama to have done something similar, he would have had to change the whole way people think about monetary policy, which is a taller order. Very hard to imagine what Obama himself could legally have done that would have had a comparable impact to going off the gold standard. Also Roosevelt entered late in the game: Obama gets some credit for avoiding a more severe depression. Personally I do see some obvious failures (leaving Fed positions open, not pushing for more fiscal stimulus early on), so I can’t give Obama an A- even on the curve, but I think the Reinhart-Rogoff thing gets him a B+.

  6. Gravatar of Adam Adam
    19. October 2012 at 11:23

    A third interpretation for liberals using this as a defense: getting policy right after a financial crisis is difficult, and thus recoveries are often slow.

    Presumably they would want to add a corollary that the president does not make policy alone, but would have been able to do a much better job of it had he gotten more cooperation from the GOP.

  7. Gravatar of Adam Adam
    19. October 2012 at 11:25

    Or what Andy said (which would have been better with paragraph breaks).

  8. Gravatar of johnleemk johnleemk
    19. October 2012 at 11:35

    Kevin Donoghue:

    “I don’t get it.”

    I noted in another thread that you don’t seem to read the posts you link to, so it’s hard to help you really. Basically the problem is, as you suggest, insufficient monetary and fiscal stimulus. Kalecki started the discussion about the political reasons for that.

    I guess you must have not read the two sentences directly after “I don’t get it.”

  9. Gravatar of Suvy Suvy
    19. October 2012 at 11:37

    This stuff isn’t true at all. I refer to the work of both Charles Kindleberger and Kenneth Rogoff on this. Usually financial crises occur when the debts can’t be rolled over. Every single asset bubble is essentially a Ponzi scheme. It’s got positive feedback on the way up and the way down. Kindleberger has done plenty of empirical work on this as has Kenneth Rogoff. Rogoff has a book which has tables and tables of over 800 years of data(This Time is Different).

    Every single asset bubble is essentially a Ponzi scheme. They rely on more people coming in than leave. Asset bubbles and financial crises usually happen when the debts can no longer be rolled over. There’s been plenty of empirical work done on this going back to the classical economists of John Stuart Mill.

  10. Gravatar of Kevin Donoghue Kevin Donoghue
    19. October 2012 at 11:49

    johnleemk, I did read those sentences, which is why the words “as you suggest” appear in my response.

  11. Gravatar of ssumner ssumner
    19. October 2012 at 11:54

    Everyone, I’m not seeing an answer to my AD vs structural query, which confirms my suspicion that there is no model there.

    Andy, That’s an argument that might make some sense. Recoveries at the zero bound tend to be slower. I wish they had made that argument instead. Of course I’d argue reverse causality and point to Japan, but at least it’s a defensible argument. It’s really unfortunate that liberals latched on to the “financial crises lead to slow recoveries argument.” I actually agree with liberals (and disagree with Romney) that AD is the problem. But it seems to me that liberals are walking into a trap, and will regret claiming financial distress leads to slow recoveries, as most people will naturally view that as a “structural” argument, and hence it will undercut the liberal call for demand stimulus. Of course we know from 1933 that industrial production can grow 57% in 4 months even with much of the financial system completely shutdown. All you need is monetary stimulus.

    On the other hand with the Germans now calling for demand stimulus, we live in a completely insane world. So I suppose any interpretation is possible.

    BTW, I agree that Obama scores higher on demand stimulus, but for me it would be C for Obama and D for Romney. And as I’ve said many times, the problem isn’t Obama or Bernanke, it’s the economics profession as a whole.

  12. Gravatar of Doug M Doug M
    19. October 2012 at 11:57

    Hmmm… An accurate forecast of a decline in demand (tight money) triggers financial crises.

    Asset prices are function of demand expectations. Declining asset prices create greater loses than some are able to bear.

    Thinking about the dot-com collapse, in that case, demand expectations, within the industry were incredibly lofty. A mere reduction in the level of growth (as a opposed to an actual decline) in demand was sufficient to cause a massive revaluation of the players and forced many out of business.

    Telecom just a couple of years later had a different problem. They accurately forecasted lofty demand for telecom services. Companies borrowed and invested in infrastructure. However, technology advances increased capacity for the existing infrastructure. Triggering an actual glut. The largest corporate bankruptcies in history followed.

    LTCM — now this one was really cool. We had a financial crisis with no decline in demand — or no decline in domestic demand. A recession in Asia, drew money into the safe markets in the US and Germany. LTCMs highly levered convergence trades diverged. LTCM collapsed and nearly took several US banks with it.

    So, back to the point, are financial crises triggered by slow recoveries? Even if we take it as a given that they are triggered by an accurate forecast of an upcoming slow down, there is nothing in asset pricing that suggests the length of that soft patch.

  13. Gravatar of marcus nunes marcus nunes
    19. October 2012 at 12:30

    Dudley has conceded the point that MP is responsible for the slow recovery.

  14. Gravatar of Adam Adam
    19. October 2012 at 12:36

    Suvy – I don’t think that’s a rebuttal. I think Scott’s saying that the debts can’t get rolled over because people are expecting slower future growth.

    Which is not to say that I’m sure Scott is right, but it’s interesting to think about it.

    I do think he’s right about the politics of it, though, and I do think liberally shouldn’t be saying slow recoveries follow financial crisis without saying that that’s because of poor policy and we need to do better than the past.

  15. Gravatar of marcus nunes marcus nunes
    19. October 2012 at 12:39

    And things get off track only AFTER NGDP tanks.Before it was just a residential construction recession.

  16. Gravatar of StatsGuy StatsGuy
    19. October 2012 at 12:40

    IMHO – the one and only thing Larry Summers got right – a lot of the slow growth is demographics.

    HOWEVER, Dems have not done a very good job dealing with the difference between slow growth and capacity underutilization. If it was just slow growth, we could blame demographics.

    Rather than confronting the argument “it’s either AD, or it’s structural, so which is it?” and doing something about it, they conjured up this magical notion of transmission mechanism failure (there’s plenty of AD, but it’s not moving through the financial system because of credit market failures), without having any clear notion or model of what they were talking about. So they ‘fixed’ a problem that wasn’t the core problem, and lost credibility.

  17. Gravatar of Suvy Suvy
    19. October 2012 at 13:06


    I don’t agree with Prof. Sumner if he’s saying that the reason the debts can’t be rolled over because people expect less growth. The problem is because there is a positive feedback loop between rising asset prices and the leverage used to buy the assets.

    Suppose you have asset prices(like houses) rising at 8-9% a year while NGDP is rising at 4-5%(like we did from 1998-2005/2006ish). In order for asset prices to keep rising at that rate, they have to take more and more and more resources form the economy because their growth is higher than the growth of the real economy. If you’re using debt to buy these assets, the costs of servicing the debt will keep rising because debt keeps rising. Now, there reaches a point where the costs of servicing the debt for the economy as a whole become so high that we reach a point where the costs overwhelm the economy as whole and the costs of servicing the debt can no longer rise. That’s when the financial crisis hits. You can keep reducing the costs to service the debt(lower interest rates), but you still reach the point where the costs of servicing debt can’t go up. The financial crisis is inevitable and unavoidable. The only way that you can keep the asset prices rising is with credit expansion, but at some point that has to stop. Then, the crash happens. Kindleberger details this very well. It’s a Ponzi scheme because you have to have more money coming in than leaving and that money has to come from somewhere(the real economy). When the money flow stops coming, the Ponzi scheme is over and people go bankrupt.

    Not only that, but I’m using a different view of expectations than Prof. Sumner. During the bubble days, people leverage up to buy assets because the return on the assets can be used to pay down their debt. However, when the asset prices stop increasing, people no longer have a way of servicing their debt because the only way they can service their debt is by selling their assets at a higher price. When the price stops rising, the speculators can no longer service their debts and a panic ensues. There becomes a rush to safety and “cash is king”. Then, when people realize the mistakes they made, there becomes a rush to sell and then comes the crash.

    In its essence, it cannot be sustained because all asset bubbles are Ponzi schemes. They rely on one and only one thing: that more money is coming in that leaving.

    I would also like to add about the importance of debt. When you have firms/individuals/a society that’s highly leveraged, a small change leads to a large impact. Take Lehman Brothers as an example. The firm was levered 30/40:1. When you’re levered that much, a small change in the price of your assets causes you to blow up. So it’s not some low probability, high impact event(black swan) that causes a blow-up because when volatility goes up as it most certainly will(since volatility fluctuates), the firm blows up. Similarly, if you have a society built on debt and one small blow up happens, other people that expect to get paid don’t get paid. Then, they can’t pay others, etc etc. Therefore, when you have a firm/society/individual that’s highly leveraged, a blow-up doesn’t become a low probability, high impact event, it becomes a high probability, high impact event(white swan). In other words, 2007-2008 wasn’t a black swan(and no one here is saying it was); it was a near certainty.

  18. Gravatar of Suvy Suvy
    19. October 2012 at 13:10

    What I’m saying is that if the growth in asset prices is not sustainable and assets keep increasing, a crash is a near certainty. Take the dot-com bubble as an example. There were firms that had P/E ratios of 1000. Does it make sense to have a company that costs $1000 but makes $1 a year? It would take $1000 years to get your initial investment back and that’s not including inflation. The stock price of that company will eventually crash.

    Also, in Mandelbrot’s book Fractals in Finance; there’s a paper where he talks about how you can actually have rational bubbles. I was looking at it yesterday. I’ll post the name of the paper when I get home and look it up

  19. Gravatar of Steve Steve
    19. October 2012 at 13:32

    ssumner: “I see a number of liberal bloggers trying to defend Obama by arguing that recoveries from financial crises are usually slow.”

    “a number of liberal bloggers” = Both of Krugman’s multiple personalities???

    Sorry, couldn’t resist.

  20. Gravatar of ssumner ssumner
    19. October 2012 at 13:50

    Doug, You do realize that the tech crash was not a financial crisis, don’t you?

    And LTCM was a single firm. There was no systemic banking crisis

  21. Gravatar of Doug M Doug M
    19. October 2012 at 14:20

    The tech crash did trigger a recession, though.

    LTCM was definately a crisis, but since the Fed successfully orchistrated a bailout of LTCMs creditors, there was no immediate fallout to the general economy.

    Before LTCM to find a US banking crisis we would get to the S&L crisis of the 1980’s. That one sort of happened in slow motion, but eventually came to a head in 1989, and did have a slow recovery.

  22. Gravatar of Doug M Doug M
    19. October 2012 at 14:21

    Seeing the tech crash as a crisis is a byproduct of living in s
    Silicon Valley.

  23. Gravatar of Bonnie Bonnie
    19. October 2012 at 14:45

    Perhaps the argument about slow recovery after a financial crisis is something a little more straight forward, like damage to the banking system in the form of tighter institutional controls on risk. At least that is one I can see having an impact, but it probably doesn’t play as large of a role as the monetary problem.

  24. Gravatar of Major_Freedom Major_Freedom
    19. October 2012 at 15:11

    There was not multiple financial crises 2007-2008. It was one big financial crisis. If you say that a 2007 financial crisis preceded the recession, then that’s it. You’ve dealt your financial crisis card. You can’t play it again late 2008. The banks were in crisis mode the whole time.

  25. Gravatar of Becky Hargrove Becky Hargrove
    19. October 2012 at 15:44

    Doug M,
    It felt that way in Austin, too. I remember it like it was yesterday.

  26. Gravatar of Paly Paly
    19. October 2012 at 16:22

    “And things get off track only AFTER NGDP tanks.Before it was just a residential construction recession.”

    marcus, that’s a very elementary, and at the same time, highly informative way of expressing the issue. It’s a different, but effective way of describing Scott’s underlying thesis.

  27. Gravatar of Tommy Dorsett Tommy Dorsett
    19. October 2012 at 17:02

    Krugman’s argument that high rates were not the cause for the 2007-2009 collapse is a fail. What caused it was the lack of a monetary infrastructure to sustain money growth at the ZLB at sufficient rates to offset the fall in velocity. In other words, the crash in NGDP was due to the administered rate failing to follow the natural rate down with sufficient force and magnitude. End of story.

  28. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. October 2012 at 19:21

    Some reflections…

    1) I haven’t taken anything John Taylor has written or said seriously in a very long time. This is mostly because I have long since reached the conclusion that he’s much more interested in winning arguments (and elections) than in seeking the truth.

    2) I have major doubts about Reinhart and Rogoff’s work. Take their paper on public debt overhangs from April for example:

    I came away thinking (counter to R&R’s conclusion) that the primary cause of public debt leverage in advanced economies, and the associated slow economic growth, is war (the Napoleonic Wars, the Belgian-Dutch War, the Third Carlist Wars, the Franco-Prussian War, WW I, WW II, the Greek Civil War, etc.) War tends to raise the debt numerator and reduce the GDP denominator. And in my opinion slow economic growth naturally follows as a result of postwar devastation and/or disarmament.

  29. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. October 2012 at 19:23

    3) I also have major doubts about Michael Bordo’s work. Take his paper on inequality and financial crises from March for example:

    Granted there are flaws with his major argument, but in my opinion his most glaring elementary error is his claim that nominal interest rates are a good measure of monetary policy stance. After all nominal interest rates were very low in the contractionary part of the Great Depression and were very high in the inflationary 1970s, and yet no one is seriously making the claim that monetary policy was loose in the Depression and tight under Arthur Burns.

    (Ironically Bordo uses a credit variable developed by Moritz Schularick and Alan Taylor (the “good” Taylor) but in his most recent paper reaches starkly different conclusions from them.)

    4) So, what about this latest tiff?

    Well, R&R’s definition of financial crisis mostly deals with things that aren’t relevant to the US Great Recession. They identify five kinds of financial crisis: 1) external sovereign default, 2) domestic sovereign default, 3) exchange rate crisis, 4) inflation crisis and 5) banking crisis. Thus their definition of financial crisis is primarily focused on issues involving public debt (exchange rate crisis and inflation crises can be a form of sovereign default), and the most serious crises nearly always involve current account reversals. The US Great Recession may have boosted public debt levels, but even R&R classify it only as a banking crisis, and if anything the global financial crisis has led to an inflow of foreign capital seeking safety. Furthermore, only a small fraction of the cases examined by R&R are banking crises involving high income countries under high capital mobility. Thus it’s not clear to me how relevant most of R&R’s research is to the US Great Recession.

  30. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. October 2012 at 19:24

    Bordo doesn’t waste much breath on explaining how he classified the episodes he studies as financial crises. Most people don’t think of the 1974 and 1982 recession as financial crisis so this came as a surprise to me as well. Bordo cites a paper by David Lopez-Salido and Edward Nelson:

    On first glance Lopez-Salido and Nelson’s evidence seems weak but it had me going back to R&R and I realized that R&R’s evidence actually seems even thinner. R&R define a bank crisis as the “closure, merging, takeover or large scale government assistance of an important financial institution”, which quite frankly is vague, and depending on one’s criteria threshold, could easily be true of the 1974 and 1982 recessions (see Lopez-Salido and Nelson for more information).

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. October 2012 at 19:24

    This morning I noticed Krugman referring to credit spreads in his blog in the context of this debate:

  32. Gravatar of Mark A. Sadowski Mark A. Sadowski
    19. October 2012 at 19:26

    And that had me thinking, what a great idea, let’s see what the credit spreads looked like in 1974 and 1982:

    By that criterion the 1974 and 1982 recessions are only slightly behind the Great Recession and well ahead of the Savings and Loan Crisis (which is classified as a financial crisis by R&R) as “financial crises” go. And for what it’s worth, in terms of actual bank closings, while there were 157 in 2010, at 119, there were almost as many in 1982.

    5) The bottom line is, I’m not sure R&R’s research is all that relevant to the US Great Recession. So if you restrict yourself to US financial crises, even limiting yourself to R&R’s list, the current recovery is weak even correcting for trend (I’ve looked at this in terms of both NGDP and RGDP). And if you include the 1974 and 1982 recession, which is not as an outrageous idea as I initially thought, it looks even worse. More importantly, I’m not even sure what the direction of causality from recession to financial crises is, provided one can even agree on an appropriate definition of “financial crisis” with respect to the US.

    I’ve always felt that what has made the current recession so bad are the poor monetary, fiscal and regulatory policies that led to it, and the poor policy responses to it. In my opinion the evocation of R&R’s “This Time is Different” has almost always been simply an excuse to do nothing. In the final analysis the Taylor exploitation of this debate is an election year distraction from an honest discussion of what constitutes better macroeconomic policy.

  33. Gravatar of J.V. Dubois J.V. Dubois
    20. October 2012 at 03:15

    I always thought that the whole slow recovery from financial recession argument is more about some mysterious force causing slow recovery than about aggregate demand or some other usual explanation.

    And the sentence “we found in data that it is the financial crisis that makes it all so hard” sounds more professional then for example a claim that “We found in data that recessions started in October seem to have historically very slow recovery and that is why we should cut our current Government some slack”.

    PS: It is remarkable how this lame excuse was almost instantly adopted by economic proffesion according to this poll (HT Marcus Nunes):

    It seems to be the next big thing after the confidence fairy that economic profession as a whole tries to evoke just so they don’t have to admit that they were wrong on the monetary policy front – which they almost universally seen as no-problematic. So sad.

  34. Gravatar of ssumner ssumner
    20. October 2012 at 06:16

    Doug, Yes, the tech crash was followed by a recession (unemployment rose to a peak of 6.3%) but I’m really having trouble following the logic of your argument. Is there some point to all this?

    Mark, Good observations. I was amused when Krugman complained that the data only showed the first 4 quarters of recovery, and then Taylor immediately showed the same results apply to the first 8 quarters. It perfectly illustrates my Krugman “bubble” post yesterday–he doesn’t take conservatives seriously, and hence keeps losing arguments he should win.

    JV, Yup.

  35. Gravatar of Steve Roth Steve Roth
    20. October 2012 at 06:33


    1. Financial markets saw a recession coming.

    2. They saw that the recovery would be slow.

    So they bid down asset prices in a self-fulfilling prophecy. A financial crisis resulted.

    What drove belief #2? Possibilities:

    A. They understood intuitively that recoveries from financial crises are slow (intuitively, because that sure wasn’t common conversation on The Street in 2008; This Time is Different hadn’t been published). If this, then “financial crises cause financial crises.”

    B. They realized that the Fed, pursuing policies unenlightened by Market Monetarism, would not react sufficiently. Nothwithstanding that Scott hadn’t started blogging yet.

    C. A combination of A and B: They realized that the Fed doesn’t respond sufficiently to financial crises, resulting in slow recoveries. Is the Fed or the financial crisis the (proleptic) cause? It’s like asking whether a hot fudge sundae is caused by hot fudge, or ice cream.

  36. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    20. October 2012 at 08:39

    Thanks for all the interesting comments and info, Mark. However, your;

    ‘In the final analysis the Taylor exploitation of this debate is an election year distraction from an honest discussion of what constitutes better macroeconomic policy.’

    The debate is about whether the Obama, ‘Don’t look at me, I just inherited the mess.’ argument is valid. Taylor is just responding to it.

    Nor does that get in the way ‘of what constitutes better macroeconomic policy.’ To wit, this blog.

  37. Gravatar of Russ Anderson Russ Anderson
    20. October 2012 at 09:56

    Aren’t financial crises and inadequate monetary growth and lack of AD all the same thing? Since the broader money supply is money multiplier effects of the financial system, obviously a disruption in the financial system (like the implosion of the shadow banking industry) will disrupt the broader money supply and create a lack of AD.

    Which way does causality run when they are really the same thing?

    Of course when a financial crisis hits reducing monetary growth and a lack of AD, the Fed could/should step in to fill the gap while the financial institution recover to maintain the broader money supply and AD. Bernanke/The Fed did do a lot of heavy lifting, but not enough to maintain NGDP (especially in late 2008) and to provide for a faster recovery. And when Fed monetary policy is inadequate fiscal policy could/should fill in.

    “Can someone help me here?” I’m not a liberal blogger but I’ll give it a shot.

    “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?” You are talking like financial turmoil and lack of AD two different things. Financial turmoil shrinks the broader money supply and AD. Government monetary and fiscal policy can/should be used to offset the effects of financial turmoil and get AD back up. Pointing out that there should have been more monetary/fiscal stimulus is not inconsistent with believing the root cause was the financial meltdown. They are claiming the recovery is slow because there has not been enough monetary & fiscal stimulus to fully offset the negative impact of the financial meltdown. It is that hard to get?

  38. Gravatar of Negation of Ideology Negation of Ideology
    20. October 2012 at 12:09

    You are correct, correlation doesn’t mean causation. If your thermostat(the Fed) is broken, it doesn’t matter what caused your house to feel cold. Fix the thermostat.

    It does no good to argue that the heater is running more than before and it’s still cold, so therefore the furnace is not working and we might as well turn it off.

    If the problem is low nominal AD, then set the thermostat to the correct nominal AD, don’t set it to something else and then complain that AD is too low.

  39. Gravatar of RebelEconomist RebelEconomist
    20. October 2012 at 13:16

    Scott: “Doug, You do realize that the tech crash was not a financial crisis, don’t you? And LTCM was a single firm. There was no systemic banking crisis.”

    That is not how it felt at the time! The LTCM / Russia crisis motivated the Fed to ease to address the “seizing up of financial markets”. The tech crash culminated in the Worldcom bankruptcy, then the largest in history, which generated scepticism about corporate balance sheets which froze the commercial paper (ie shadow banking) market for a while and led to Sarbanes-Oxley.

    As I have written here before, in my view the reason why the financial crises often generate such long downturns is that the authorities usually react by trying to forestall the problems, by changing accounting rules and easing monetary policy regardless of inflation. Investors are not fooled, however, and avoid major commitments pending a resolution. If I am right, the US should recover relatively quickly, because monetary policy has not been eased excessively (inflation has not overshot unlike in the UK), many banks have been resolved (unlike in Europe) and house prices have been allowed to fall with widespread foreclosures (unlike in the UK and Spain). I suspect that the present financial crisis would have been much reduced or even avoided altogether had the Fed set the pain threshold a bit higher in 1998 and the early 2000s.

  40. Gravatar of Suvy Suvy
    20. October 2012 at 15:21

    The paper I was referring to was Nonlinear Forecasts, Rational Bubbles, and Martingales in the Journal of Business, 39, 1966, p 242-255.

    Basically, the essence is that if you don’t assume that the errors are random(like the Rational Expectations theory foolishly does) and that the price movements are correlated(which is clearly true if you calculate the Hurst exponent of almost every single financial time series); then the behavior you get will be much more realistic. In other words, if you make more realistic assumptions you get more realistic (and more interesting) behavior.

    Essentially, if you have correlated price movements and non-random error–which is clearly true(calculate the Hurst exponent of the Dow Jones over the past 50 years, H won’t be .5); then bubbles and crashes become far more common. In other words, crashes don’t happen because the market forecasts that NGDP will drop; they occur because the behavior is nonlinear and correlated. Of course, any good trader clearly understands this.

  41. Gravatar of Chris Corn Chris Corn
    20. October 2012 at 20:24

    Prof. Sumner there is no real AG. The structural issues are being built on a daily basis. It’s like the project from hell that never gets finished because the contractor is totally incompetent. While I know that you favor a certain futures market that really NEVER can exist in the REAL world, I belive that the fed does see your point and is trying in a REAL world setting but as of yet to no avail. I think this sums it all up, with special emphasis your statement that ” markets are forward looking.”

  42. Gravatar of Jon Rodney Jon Rodney
    21. October 2012 at 05:35

    Here’s Krugman making the exact same point as Andy — financial crises tend to have slower recoveries because they tend to bump up against the zero lower bound.

  43. Gravatar of ssumner ssumner
    21. October 2012 at 06:00

    Rebeleconomist, How it “feels at the time” has little bearing on how something really is. How did 2008 feel at the time? Did it “feel” like tight money? On the other hand if it was a financial crisis, then Russ Anderson’s post is wrong, AD and financial crises are not inextricably linked.

    Russ, Surely there must have been financial crises during periods of soaring inflation? How about Indonesia 1998? Perhaps someone can check.

    Chris Corn, When a comment seems completely unintelligible (what is real AG?) I’m not inclined to follow up by checking out the attached link.

    Jon, Taylor just blew him away in that debate. Krugman should have focused on the zero bound problem, not the financial crisis angle.

    Steve, You said;

    “They realized that the Fed, pursuing policies unenlightened by Market Monetarism, would not react sufficiently. Nothwithstanding that Scott hadn’t started blogging yet.”

    Nice try at sarcasm, but surely even someone like you must see the truth. The markets realized Bernanke had no intention of following the policies that he had earlier recommended the Japanese follow at the zero bound. That was the wake-up call. Is that so complicated?

  44. Gravatar of RebelEconomist RebelEconomist
    21. October 2012 at 08:39

    How did 2008 feel at the time? Like a continuation of events unfolding in 2007, which included the biggest shock from the point of view of the British public – the run on Northern Rock. And I mean the whole of 2008, including the demise of Bear Stearns. Like many, if not most, of your commenters, I simply do not buy the idea that tighter monetary policy in LATE 2008 caused the economic downturn. It was inevitable long before that. For example, I happened to come across this Krugman post from JANUARY 2008 earlier:

  45. Gravatar of Doug M Doug M
    21. October 2012 at 13:26

    “How did 2008 feel at the time? Did it “feel” like tight money?”

    What does tight money feel like?

    Auction Rate preffered market dried up then asset-backed commerical paper. The “shadow banking system” ran out of sources of funds. By the middle of 2008, the rest of the banking system was funds having a hard time geting funded. Lehman collapesed when they were shut out from the market for overnight cash.

    Yes, that feels like tight money.

    Was LTCM a crisis? Wikipedia lists it here…

  46. Gravatar of Peter N Peter N
    21. October 2012 at 16:40

    I think it’s premature to give up on aggregates, just because the old Fed aggregates weren’t very good.

    The Divisia M4 series shows unequivocal tight money trend starting in 2008. It fell from 10% growth year over year in mid 2008 to -8% in mid 2010 crossing from positive to negative territory in early 2009. It’s a very good fit.

    It also seems to indicate a solid recovery starting in mid 2010 but slowing down in mid 2011. The timing would be right to blame the slowdown on the European situation.

  47. Gravatar of Major_Freedom Major_Freedom
    21. October 2012 at 16:51

    Peter N:

    I think it’s premature to give up on aggregates, just because the old Fed aggregates weren’t very good.

    How about giving up on aggregates because they are merely statistical effects of, not causal engines for, economic phenomena?

    How about giving up on aggregates because they necessarily mask the relative valuations which are the actual causal engines for economic phenomena?

  48. Gravatar of Major_Freedom Major_Freedom
    21. October 2012 at 17:34


    Everyone, I’m not seeing an answer to my AD vs structural query, which confirms my suspicion that there is no model there.

    You probably didn’t see an answer to that query because you didn’t pose any query.

    You made an assertion that presupposes the cause for the slump/recession/crisis was inadequate NGDP. You wrote:

    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.

    Here’s a response: NGDP does not fall absent market actors reducing their spending. You are making NGDP out to be a deux ex machina, that rises and falls completely independent of market actor behavior. So you believe that all market actors just wait around for NGDP, and if it grows, they invest more, and if it doesn’t grow, they invest less.

    Don’t you realize that NGDP is in part a FUNCTION of investment? If NGDP falls, then chances are investment is already falling. It’s not like NGDP falls first for no reason, and then investment falls.

    Market actors don’t care about NGDP. Market actors did not make any expectation of NGDP, nor did they believe that it was going to fall before it did, nor did they then respond by investing less before it did. The fall in NGDP was contemporaneous with the fall in investment.

    Your NGDP model is not considering the following questions:

    1. Why, given that the Fed was not burning dollar bills nor telling banks to destroy demand deposits, did cash demand suddenly increase for a large proportion of the population, and, equivalently speaking, why “spending” suddenly fell for a large proportion of the population (which is necessary for NGDP to fall), and

    2. Why some industrial sectors (e.g. Construction, durable goods) suffered so drastically differently from other sectors (e.g. Retail, service sector).

    The lack of considering these two issues confirms my suspicion that “there is no model there.”

  49. Gravatar of RebelEconomist RebelEconomist
    22. October 2012 at 00:26

    Doug M, your comment raises an interesting question. Yes, the unfolding financial crisis raised the cost of short-term funding as credit spreads widened, although spreads had arguably been too narrow anyway, because they embedded assumptions about informal support from banks (for ARS and money market mutual funds). Would you say that the central bank is supposed to compensate for such spread changes, or should it concern itself with risk-free rates only (overnight Fed funds are almost risk-free, and most other central banks target a secured rate anyway)?

    At the time, I thought some kind of shakeout was appropriate, so I was in favour of holding policy rates, but I think that mistakes were made by not setting limits on the damage early in the process, such as by nationalising Lehman and by forbidding banks to support SIVs to which they were not formally committed for reputational reasons.

  50. Gravatar of ssumner ssumner
    22. October 2012 at 16:01

    Rebeleconomist. Sure it was “inevitable” in some cosmic sense, including the incompetence of policymakers. But that’s the entire problem. Most economists and the financial markets were not predicting a huge slump as late as mid-2008, and it would not have occurred if policy has continued to stabilize NGDP, as during the Great Moderation.

    Why didn’t policy ease in September 2008? There is no way they would have refrained from easing under similar conditions during the Great Moderation.

    The market monetarists are trying to make what was inevitable, no longer be inevitable under similar conditions next time. And now that Fed officials like Dudley are admitting they blew it, it seems like we are making progress.

  51. Gravatar of RebelEconomist RebelEconomist
    23. October 2012 at 00:08

    I suppose I have in mind, Scott, “inevitable” in some kind of Austrian sense – like undergrowth that will inevitably burn, better in small annual fires than multidecadal conflagrations. But it is late in this comment thread, so perhaps you would care to pick up on this in a future post – whether stability (in NGDP if you like) can be excessive and/or would need to be supported by other stabilisation policies, such as more regulation.

  52. Gravatar of Chris Corn Chris Corn
    23. October 2012 at 02:20

    Ok sorry for my typo in my post. I guess i get an F from the Professor on that. AG should be AD and I was addressing the question you posed. As for the link, after Major Freedom’s post that followed , you don’t even have to bother. As far i am concerned, Major is hitting the nail on the head. Thanks for sticking up for me Major against a bully.

  53. Gravatar of Saturos Saturos
    23. October 2012 at 04:01

    MF, David Beckworth has answered 1), Bryan Caplan has answered 2).

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