In the 1930s it seemed "obvious" that financial turmoil had caused the Great Depression
But now we know the actual problem was tight money, which caused NGDP to fall in half.
Here’s Noah Smith:
This seems to be the overwhelming consensus in academic macro these days. It seems obvious to most people that the Great Recession was caused by stuff that happened in the financial sector; the only alternative hypothesis that anyone has put forth is the idea that fear of Obama’s future socialist policies caused the recession, and that’s just plain silly.
Perhaps some day economists will realize that the models they were teaching their students in 2007 imply that the world’s central banks caused the Great Recession.
Here’s Ludwig Wittgenstein:
Tell me,” the great twentieth-century philosopher Ludwig Wittgenstein once asked a friend, “why do people always say it was natural for man to assume that the sun went around the Earth rather than that the Earth was rotating?” His friend replied, “Well, obviously because it just looks as though the Sun is going around the Earth.” Wittgenstein responded, “Well, what would it have looked like if it had looked as though the Earth was rotating?
Now let’s assume Wittgenstein was a market monetarist:
Wittgenstein: Tell me, why do people always say it’s natural to assume the Great Recession was caused by the financial crisis of 2008?
Friend: Well, obviously because it looks as though the Great Recession was caused by the financial crisis of 2008.
Wittgenstein: Well, what would it have looked like if it had looked like it had been caused by Fed policy errors, which allowed nominal GDP to fall at the sharpest rate since 1938, especially during a time when banks were already stressed by the subprime fiasco, and when the resources for repaying nominal debts come from nominal income?
Inevitably when I make this argument there are a few tiresome “people of the concrete steppes” who insist the Fed did not cause the recession, they merely failed to offset the fall in velocity. Unfortunately they haven’t bothered to look at the data. After rising at roughly a 5% rate for many years, the Fed brought growth in the monetary base to a complete halt between August 2007 and May 2008. That triggered the onset of recession in December 2007. Velocity actually rose during that 9 month period, but not enough to offset the Fed’s tight money policy.
Of course later on V did fall sharply, and the Fed failed to take affirmative steps like level targeting of NGDP, which would have prevented the mild recession from turning into the Great Recession. But it’s the Fed’s job to control AD. When they do it well they take credit for their success, as when they took credit for the Great Moderation. And when they fail? Well let’s just say Milton Friedman would not be surprised by any of the Fed’s recent excuses. Here he describes what it’s like to read all their annual reports, back to back:
An amusing dividend from reading annual reports of the Federal Reserve System seriatim is the sharp cyclical pattern that emerges in the potency attributed to monetary forces and policy. In years of prosperity, monetary policy is a potent instrument the skillful handling of which deserves credit for the favorable course of events; in years of adversity, other forces are the important sources of economic change, monetary policy has little leeway, and only the skillful handling of the exceedingly limited powers available prevented conditions from being even worse.
There were only 45 reports to read back in 1959. Now there are 100. But nothing has really changed.
PS. I do understand that Noah’s “financial system” could be read as including central banks. But the rest of his post makes clear he is looking at the financial causes in the same way as 99% of other economists do–banking distress and associated problems.
PPS. A note on my earlier comment that we’ve forgotten everything we taught our students back in 2007. I was thinking of these sorts of lessons, which back in 2007 appeared in the number one money textbook (by Frederic Mishkin):
It is dangerous always to associate the easing or the tightening of monetary policy with a fall or a rise in short-term nominal interest rates. . . .
Monetary policy can be highly effective in reviving a weak economy even if short term rates are already near zero.
In my earlier days of blogging (in 2009) I tried to do a humorous take on how everything changed after 2008:
Now I’m starting to feel like Kevin McCarthy in the film Invasion of the Body Snatchers. Have I “misremembered” my history of progress in 20th century macro? Has some quantum fluctuation plunged me into a parallel universe where post Keynesian theory accurately describes the laws of macroeconomics?
I try to remain dispassionate and look at things logically. What are the odds that some pod-people from space have not only rewired Paul Krugman’s brain, but that of most other macroeconomists? Isn’t it more likely that I am going crazy? Like a character in a Borges story, I am now afraid to open Mishkin’s textbook, for fear that the passage I remember may not be there. If you see a tall thin guy at the Harvard or MIT economics parking lots, jumping on the windshields of cars, please call the appropriate authorities.
Now I can update that story. There’s a scene at the end of the film where the authorities hear of a truck overturning that is full of giant pods. There’s a palpable shudder as they realize that Kevin McCarthy is no raving lunatic. I had a similar feeling when I opened the newest addition of Mishkin’s text, and found that “highly effective” was no longer there, merely “effective.” Here are some other mysterious changes in Mishkin’s text.
It’s starting to happen. Keep an eye on Noah Smith, I fear he may be one of the space aliens.
PPPS. Marcus Nunes has a reply to my previous post. I have no objection to his claim that money was not too tight during 2003-06. I also have no objection to the claim that money was too tight, given the Fed’s 2% inflation target, or even a “dual mandate” of 2% inflation target plus minimizing the output gap.