What if we had a financial crisis without tight money?
By Scott Sumner
In the comment section of a recent post, Thomas Hutcheson and I discussed what would happen if there were a financial crisis without tight money (defined as sharply falling NGDP growth.) It’s not easy to find examples, because financial crises are often caused by slowing NGDP growth.
Here’s a graph of the number of bank failures in the US each year, from a post by Bill McBride:
The next graph takes a closer look at recent decades. Notice that bank failures peaked at roughly 500 per year in 1988-89. This remains the largest number of failures since the Great Depression.
So how did the financial crisis affect RGDP growth? Growth was about 4% during those years, pretty robust when considering that we were fairly far along in the recovery (growth is often faster during the period when unemployment falls rapidly, such as 1983-84):
Why was growth strong despite the financial crisis? Because monetary policy kept NGDP growing at a robust rate:
Actually, the 8% NGDP growth was excessive, and helps to explain why we fell into recession in late 1990. But even a 6% NGDP growth rate would have prevented the financial crisis from causing a recession (and might have also helped us to avoid the 1990-91 recession.)
Let’s consider some objections:
1. You could argue that 2008 was different, as we also had a huge stock market crash. But in late 1987 we had a stock market crash roughly the size of the famous 1929 crash. That means we avoided recession in 1988 and 1989 despite BOTH a 1929-style stock market crash and the largest number of bank failures since 1933.
2. You could argue that the 2008 bank crisis was more severe; indeed the entire banking system froze up during the fall of 2008. That’s true, but even after the Fed (and Treasury) provided liquidity and rescued the system in October, the economy continued to plunge downhill in November, December, January, February and into March. Only when the Fed switched to a more expansionary monetary policy in mid-March did the stock market, and later the economy, begin to improve.
3. You could argue that 2008 was different because we were at the zero bound. Except that we were not, at least not until mid-December 2008. The Eurozone didn’t hit the zero bound until about 2013, and yet they had a recession just as bad as the US.
4. You could argue that we didn’t have a housing slump in 1988-89, except that we did. Home prices fell in many key coastal markets during the late 1980s, and home construction slumped during this period:
Yes, the housing slump of 2006-09 was even worse, but during the first half of that slump the economy was not even in recession.
Before you put too much weight on the differences between the late 1980s and 2008, I want you to consider the following:
Despite the highest levels of bank failures since 1933, and despite a stock market crash of 1929 proportions, and despite a real estate slump, the economy of 1988-89 actually accelerated to above 4% RGDP growth. In other words, not only were these shocks not severe enough to cause a deep recession, they didn’t even cause a tiny slowdown in growth.
Are the things that you think caused the 2008 recession really enough orders of magnitude worse than 1988-89 to explain the difference between no economic slowdown at all and the worst recession since the 1930s? Seriously?
Or, do the very different paths of NGDP growth during those two periods better explain the dramatic difference in the path of RGDP growth?