The standard story of the Great Recession has housing play a key role. There were lots of subprime mortgages, and when the housing bubble burst there was a big increase in defaults. This led to a banking crisis and a general fall in aggregate demand.

I’ve suggested a different interpretation. Instead of the housing crisis getting worse and worse, until it brought down the financial system and pushed us into recession, the recession of 2007-09 dramatically worsened the housing bust, and led to a much more severe banking crisis. It’s not unusual for a big drop in NGDP growth to lead to a financial crisis, and 2008-09 saw the biggest drop since the 1930s. I often use the analogy where someone gets a cold, which gradually turns into pneumonia. They might erroneously assume the initial cold got worse, not that a viral illness turned into a very different bacterial infection. A new NBER study by Fernando Ferreira and Joseph Gyourko (summarized by Les Picker) seems to provide evidence that something fundamental did change after 2008:

The researchers find that the crisis was not solely, or even primarily, a subprime sector event. It began that way, but quickly expanded into a much broader phenomenon dominated by prime borrowers’ loss of homes. There were only seven quarters, all concentrated at the beginning of the housing market bust, when more homes were lost by subprime than by prime borrowers. In this period 39,094 more subprime than prime borrowers lost their homes. This small difference was reversed by the beginning of 2009. Between 2009 and 2012, 656,003 more prime than subprime borrowers lost their homes. Twice as many prime borrowers as subprime borrowers lost their homes over the full sample period.

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The first part of the housing bust (2006-08) is fairly well understood. But the first part wasn’t the problem. Ben Bernanke testified (quite correctly) that the losses were not enough to threaten the US banking system. The unemployment rate barely changed from January 2006 to April 2008, despite housing construction falling in half. Even in the spring of 2008, the consensus of economists did not predict a recession, despite the fact that the subprime debacle was well understood. And they were right to not predict a recession, or at least a severe recession, as the key mistakes had not yet been made.

So then what caused the Great Recession. What had not yet happened in the spring of 2008? The answer is simple, the great NGDP crash of 2008-09 caused a similar decline in RGDP. And this was caused by an excessively tight monetary policy. In this recent post, I point out that elite opinion is beginning to catch up to market monetarists, recognizing that low interest rates and QE don’t mean easy money, and that you need to look at other indicators like TIPS spreads and equity prices. (Or better yet, NGDP futures.)

Once NGDP started plunging, the real estate market took another deep plunge. Now even states that avoided the subprime bubble (like Texas) were swept up in the downturn. As real estate prices fell much further than most expected, even prime loans came under stress. Bernanke was right that the subprime bubble popping wasn’t big enough to bring down the banking system, but this much larger crisis was. Again, from the NBER newsletter:

None of the other ‘usual suspects’ raised by previous research or public commentators–housing quality, race and gender demographics, buyer income, and speculator status–were found to have had a major impact. Certain loan-related attributes such as initial loan-to-value (LTV), whether a refinancing occurred or a second mortgage was taken on, and loan cohort origination quarter did have some independent influence, but much weaker than that of current LTV.

The authors’ findings imply that large numbers of prime borrowers who did not start out with extremely high LTVs still lost their homes to foreclosure. They conclude that the economic cycle was more important than initial buyer, housing and mortgage conditions in explaining the foreclosure crisis. These findings suggest that effective regulation is not just a matter of restricting certain exotic subprime contracts associated with extremely high default rates. [Emphasis added.]

The more we know about the Great Recession, the more it looks like the predictable result of a massive contractionary monetary shock in 2008. Over at TheMoneyIllusion I have a new post discussing one of the Fed’s key decisions, which contributed to that shock.

PS. I presume someone will question my claim that economists were right not to predict a recession in the spring of 2008. Here’s an analogy. Two economists observe a die toss. One predicts 1 or 2, the other says it will be 3, 4, 5 or 6. The actual result is 2. My claim is that the economist who got it wrong made the better prediction. On average, he would have been correct. My view is not popular among economists. Like astrologers, economists show respect to those in their community who have made successful guesses about business cycles and asset price movements. One even won a Nobel Prize.