Why, Oh Why?

This October we will celebrate, if that is that right word for it, the 90th anniversary of the stock market crash from which many mark the start of the Great Depression of the 1930s which persisted despite strenuous efforts right up until World War II broke out, in the process changing our views about what the economy, politics, and government should do. It is one of the mileposts by which we reckon our history. There is before the Great Depression and after it.

There have probably been hundreds of books written trying to explain the depression, its causes, and why it persisted so long most completely forgettable but some, notably Keynes’s 1936 book Employment, Interest and Money, tremendously influential. We still don’t know and there are probably as many explanations as there are analysts, many of them, unsurprisingly, justifying views that the author held before engaging in his or her analysis.

I have little doubt that the same will be true of the Great Recession. Hundreds (at the very least) of books have already been written about it. This morning Robert Samuelson devotes his Washington Post column to commentary on the most recent salvo, by Ben S. Bernanke, Timothy F. Geithner and Henry M. Paulson Jr. Without reading it I feel confident in saying that it justifies all of their actions and blames every bad thing that happened on somebody else. Here’s a snippet from Mr. Samuelson’s commentary:

The book is a CliffsNotes for the crisis. The 129-page text provides a lucid chronology, followed by nearly 100 pages of charts and tables. The authors no doubt hope that their narrative buttresses their reputations. Still, most of their analysis rings true, with one glaring exception: their theory of what created the crisis.

Here’s one passage, “The story of how the crisis happened is . . . about risky leverage, runnable funding, shadow banking, rampant securitization, and outdated regulation.” A rough translation: Lenders lent too much, borrowers borrowed too much, and arcane financial instruments stymied regulators from stopping the process.

This is the conventional wisdom. It’s also wrong, because it mistakes the crisis’s consequences for its underlying cause. The cause lay in the delusional beliefs that the economy had changed so much that practices that in the past would have been considered risky were no longer so.

Everyone drank the Kool-Aid, so to speak. Economists argued that the business cycle had smoothed. They called this the Great Moderation. Recessions would be shorter and less severe than in the past. This seemed to be confirmed by the decade-long expansion in the 1990s, the longest in U.S. history.

Would it be too snide of me to suggest that the Great Recession itself and the long, phlegmatic recovery that followed shared a common cause, summarizable in four words? The Fed screwed up.

At the very least I think it is not unfair to blame the surge in the prices of financial instruments, e.g. the DJIA went from 11,000 to 26,000 today, on the Fed. That was the stated objective of the policy the Fed deployed to spur economic growth, blandly deemed “quantitative easing”. Translated: giving money to rich people in the hope that they would invest in the real economy. It has not succeeded, at least not in the domestic economy.

Whatever the causes of the Great Recession and the slowness of the recovery, very little has been done to change the system that was in place prior to 2008. Banks sustain even less risk than they did then, presumably in the hope that less risk will induce bankers to behave more responsibly.

My modest proposal is that there should be consequences for bad behavior. Consequences for managers, consequences for bankers, consequences for politicians, and consequences for Federal Reserve governors. It is only human for people to persist in their folly as long as they face no consequences for doing so. Managers, bankers, politicians, and Federal Reserve governors are far from philosopher-kings.

8 comments… add one
  • steve Link

    The causes of the Great Recession will be debated for a long time, on that I agree. I just find it odd that some people feel like they need to find one unifying cause, when I think it much more likely that it had many causes. When you look at disaster analysis what you usually find is that takes multiple things to go wrong to have a true disaster. It took very many steps to make the Great Recession happen. You can try to prioritize those causes, and I suppose that has some real value if we could agree, but I think this will mostly be a competition to blame whatever/whoever you dont like.


  • I don’t think it’s too much of a stretch that when someone says “I’m going to do X to accomplish Y” and they do X and Y happens, to attribute Y to X. The Fed told us why they were implementing quantitative easing. It just didn’t have the run-on effects they said they wanted.

    To be honest I attribute that, at least in part, to the triumph of econometrics. It used to be that economists realized that economics was a science of human behavior. That began to change in the 1940s but changed dramatically in the 1970s to the point where economists didn’t really understand human behavior very well at all.

  • TastyBits Link

    We all knew this was coming.

    The Great Depression and the Great Recession were caused by the same thing. Asset inflation could not keep up with credit expansion, and once everybody realized ‘the Emperor had no clothes’, the financial system froze up.

    You have the mileposts wrong. The first milestone was the Fed creation, and the next was Glass-Steagall creation. The next was LBJ removing the gold cover, and it was shortly followed with Nixon closing the gold window. The repeal of G-S was next, and it was followed by the Financial Collapse of 2008.

    The Banking Act of 1933 (Glass-Steagall) was the result of hearings by Sen. Glass and Rep. Steagall. They hauled in people from the banking industry, gave them immunity, and told them to start talking. They learned that the Investment Banks were obtaining capital from the Commercial Banks through an unofficial network (shadow banking), and G-S was the result.

    Since Sen. Dodd and Rep. Frank did not learn what caused the Collapse, their legislation will ensure there will be another Collapse, and historically, these things happen far sooner than expected.

    It should be noted that, for the most part, everything being done was legal. To my knowledge, the financial institutions did not exceed their capital requirements, and Timothy Geithner, among others, actively prevented raising those limits for the institutions he was regulating.

    While this allowed the banks to create more credit to lend, it was not the only source of credit creation. It can be argued through the globalized trade-deficit (eurodollar) system, Europe was the cause.

    MMT correctly describes how money is created, but instead of the private financial institutions creating money, they propose that the government should do it. There is no difference between the two, and neither capital requirements nor asset inflation can regulate the ability to easily create credit to be used for lending.

    Fractional reserve lending allows money that does not exist to be lent. This is its only purpose. The Fed allows this to be concealed through the amalgamation of the private banks in its system. Without the Fed, fractional reserve lending banks can only issue bank notes not dollars, or they can lend their deposits.

    Yes, Virginia. Your economics professor had no idea of how banking works. When Jill deposits $100 and you lend $90 to Jack, that is fully reserved lending. If Jack defaults on his loan, the bank is insolvent, and Jill loses her $100 minus anything recovered.

    When Jill deposits $100 and the bank lends Jack $900, that is reserved lending. If Jack defaults on his loan, the bank is insolvent. Jill loses her $100 minus anything recovered, but now, everybody holding the bank notes lose $900.

    Actually, your economics professor has no idea that it is capital requirements that limit lending. Deposits allow the Fed to practice fractional reserve lending, also.

    Fractional reserve lending is dangerous because of leveraging. If Jack deposits his $900 into a bank, that bank can now lend $8,100, and if that borrower deposits it into another bank, it can lend $72,900. If you can spot the problem, raise your hand.

    (NOTE: This is a simplified version of how it works, and I am fully aware that this is an extreme example to illustrate the problem.)

    Lastly, lowering the inflation rate and raising the capital requirement are, at best, crude methods of regulating the system.

    For money creation, there are no objective limits. If a 2% inflation rate or 10% capital requirement are good, is a 4% inflation rate and 5% capital requirement better? If so, why? If not, is a 1% inflation rate or 20% capital requirement better? If not, why?

    … econometrics …

    It is an attempt to induce objectivity into a system that economists do not understand must be subjective. The Fed stopped tracking M3 because they had no idea of what it was or why it was useful.

  • Just as a reminder the strategy that was chosen in 2007-2008 was not my preference. I thought we should have nationalized the insolvent banks. Several other countries have done that and dug themselves out of holes like the one we were in much more quickly than we have. Additionally, at the time former Treasury folks claimed that we did, in fact, have the ability to handle big bank failures. In other words the shareholders would have taken it in the ear but that’s the way a market system is supposed to work. Presumably, they’d’ve done things differently the next time.

    But we elected to preserve the shareholders at all costs and, as a result, nothing has changed except that (due to QE) rich people are a lot richer now.

  • TastyBits Link

    The housing bust was the proverbial “slow moving train wreck”. It began in the sub-prime Adjustable Rate Mortgage resets of 2007 and continued into 2008.

    The financial collapsed was caused by a run on money market funds. Had money markets been moved under FDIC protections, the results of the collapse could have been mitigated. There would have been loses, but lending would not have seized-up.

    Since the FDIC has an existing playbook for bank failures, they would have mitigated the losses, and the financial industry would have been provided a soft backstop. AIG would have defaulted on their CDS’s, and their would have been a lot of new poor or non-really rich people.

    At that point, an updated G-S should have been enacted, but instead we got the Dodd-Frank.

  • Guarneri Link

    “Everyone drank the Kool-Aid,”


    And as for the consequences. I’ve been steadfast in the “standard model.” The equity gets wiped out for their mistakes, then move up the cap structure. Look to the pols and left for disagreement with that.

    There is a lot to be said about the first 2/3rds of Tasty first post. It’s fundamentally spot on.

    I think Dave and I have a different view on the definition of econometrics. It’s just a statistical tool.

    I hope everyone knows that had the housing asset collapse been the only thing at work we would have had no Great Recession. We would have had a housing correction, with attendant effects. But when banks didn’t know what other banks had on their balance sheets (like swaps) the normal liquidity functions of the banking system seized up, along with the commercial paper market. Shorter: we had a liquidity crisis and the shit hit the fan. It makes the case for Dave’s suggestion of nationalizing banks, as long as then you follow my view of wiping out the cap structure from the equity up.

  • TastyBits Link

    … nationalizing …

    Nationalizing and socialism get thrown around a lot. Would somebody please give me a definition? Do you all mean that the government would own the banks? You all are scaring the hell out of me.

  • Guarneri Link


    Relax. The point is that in a liquidity crisis crazy shit could happen. Contagion. If you nationalize you could conduct an orderly “standard model” restructuring.

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