The consensus view is that the Great Recession of 2008-09 was caused by financial instability. I think this view is wrong and I wrote a whole book arguing that it was a lack of money that caused the Great Recession. A recent Bloomberg article perfectly illustrates why it’s important to understand what went wrong in 2008:
The FSOC released its first study Friday on the threats posed by nonbank mortgage companies, which have escaped the strict regulation reserved for traditional banks despite being crowded out of the market. In 2022, non-banks originated about two-thirds of mortgage loans and serviced most of them.
The sector’s specialized business model makes companies vulnerable to changes in property prices, interest rates and delinquency rates, the report said. Nonbanks rely more than traditional lenders on the value of mortgage servicing rights, and they may have high leverage, short-term financing, and operational risks, the FSOC found.
“Simply put, the vulnerabilities of nonbank mortgage companies can amplify shocks to the mortgage market and undermine financial stability, and the council has laid this out in detail for the first time,” Treasury Secretary Janet Yellen said. , who heads the FSOC.
Not surprisingly, this view has led to calls for greater federal involvement in the mortgage market, which would further exacerbate the mortgage problem. moral hazard. Previous attempts to make our financial system more stable failed because the underlying problems were misdiagnosed. Financial instability has two root causes:
1. Monetary Policy this causes unstable growth of NGDP.
2. Federal regulations that increase moral hazard by insuring depositors and designating certain banks as “too big to fail.”
Commercial bank failures have policy implications because they may require bailouts of depositors by the FDIC. However, this argument does not apply to the failure of non-bank mortgage companies. There is no reason for regulators to be concerned about non-bank bankruptcies, since any impact on aggregate demand can and should be offset by monetary policy adjustments.
This is why it is so important to have an accurate understanding of what went wrong in 2008. If policymakers correctly understood the causes of the Great Recession, they would focus less on preventing bank failures and more on the stabilization of the evolution of nominal GDP. .
PS. The same goes for the Great Depression. In the United States, the two main problems were banking regulation, which led to the creation of too many small, undiversified banks, and monetary policy which caused the NGDP to fall by almost half between 1929 and 1933 Countries with less restrictive banking regulations and more expansionary monetary policy have significantly improved their situation. better than the United States. This summary comes from a Journal of Economic History article by Richard Grossman:
This article attempts to account for the exceptional stability demonstrated by the banking systems of Great Britain, Canada and ten other countries during the Great Depression. It considers three possible explanations for stability – the structure of the commercial banking system, macroeconomic policy and performance, and lender of last resort behavior – using data from 25 countries in Europe and North America. The results suggest that macroeconomic policy – particularly exchange rate policy – and banking structure, but not lenders of last resort, were systematically responsible for banking stability.
The Fed was created to be a “lender of last resort.” But it did not address the underlying weaknesses of the U.S. financial system, which did not involve a lack of liquidity. As a result, the financial system was even more unstable in the first decades of the Fed’s existence than it had been in the two decades before the Fed’s founding.
If you don’t properly diagnose a problem, the solution may be ineffective.
PS. Some people tell me that financial instability must have contributed to what I called the “monetary tightening policy” of 2008. Take the example of a truck driver who dozes off and has an accident when the road turns. In some way, the bend in the road contributed to the accident. But the biggest problem was the dozing driver.
