Tuesday, February 7, 2017

Mark Thoma — The Great Recession: A Macroeconomic Earthquake

Larry Christiano on why the Great Recession happened, why it lasted so long, why it wasn't foreseen, and how it’s changing macroeconomic theory (the excerpt below is about the last of these, how it's changing theory)….
More like a macroeconomic brain fart.
They still don't get that a financial crisis that was foreseeable led to contagion in the real economy when liquidity dried up and banks as the primary suppler of funding to the private sector stopped lending. The government did not act quickly enough to halt the contagion and then failed to accommodate the increased liquidity preference of the private sector with sufficient federal spending. Instead, the initial stimulus was too little, too late, and then it was replaced by "expansionary fiscal austerity" to stimulate "business confidence."

The reaction of the Fed was initially to add liquidity, but it was too late to prevent the financial crisis from spilling into the economy. The Fed's next step was to add funding to the economy by increasing liquidity further was misguided because it was based on a false analysis of money creation based on the so-called money multiplier. 

The low rate policy to discourage saving and spur  investment was ineffective owing to greatly increased liquidity preference and tighter credit conditions. Moreover, QE deprived the private sector of funds that it would have received from interest payments on government securities, further enforcing the fiscal austerity imposed by Congress.

The financial crisis was initially produced by a criminogenic environment in finance that regulators permitted to develop, which had been predicted by previous work of Minsky, Kindleberger, Akerlof, Shiller, Black, and others. The FBI had warned of it in December, 2004.

Mortgage fraud was the proximate cause of the crisis but the most significant factor was the designer financial products based on derivatives that resulted in increased systemic risk rather than spreading risk as advertised.

The financial crisis led to a credit crisis that spread quickly through the economy. Most people in positions or authority and responsibility did not understand what was happening and were therefore powerless in addressing it.

Diagnosis: moronism. 

Treatment prescription: replace the morons with people who know what they are doing.
Mark Thoma | Professor of Economics, University of Oregon 


MRW said...

Sooper-dooper inconsequential minor quibble.

“The FBI had warned of it in December, 2004.”

It was September, 2004.

Tom Hickey said...

Thanks, MRW.

I was conflate that with this.

According to a December 2005 press release from the FBI, "mortgage fraud is one of the fastest growing white collar crimes in the United States".


Postkey said...

"Mortgage fraud was the proximate cause of the crisis but the most significant factor was the designer financial products based on derivatives that resulted in increased systemic risk rather than spreading risk as advertised."

Due to the 'incompetence' of the financial sector?

“The problem was not that the economy could not climb down from a situation of irrationally exuberant and elevated asset prices without a major recession. The problem lay in the fact that the major money center banks were using derivatives not to lay subprime mortgage risk off onto the broad risk bearing capacity of the market, but rather to concentrate it in their own highly leveraged balance sheets. The fatal misjudgment on Greenspan’s part was his belief that because the high executives at money center banks had every financial incentive to understand their derivatives books that they in fact understood their derivatives books.
As Axel Weber remarked, afterwards:
I asked the typical macro question: who are the twenty biggest suppliers of securitization products, and who are the twenty biggest buyers. I got a paper, and they were both the same set of institutions…. The industry was not aware at the time that while its treasury department was reporting that it bought all these products its credit department was reporting that it had sold off all the risk because they had securitized them… “