There is only one respect in which the housing crisis in the mid-2000’s differs from all other crises, except for one – the Great Depression. It was not managed well by the central banks around the world, mainly by looking at the wrong side of the balance sheet, misdiagnosing the problem as a credit problem rather than a demand (monetary policy) problem and trying to fix the banks as the black hole of collapsing NGDP that commenced in July of 2008 started sucking in everything that wasn’t nailed down. This is what turned a garden variety recession into the Great Recession, the same thing that turned a recession into the Great Depression back in the 1930’s.

It is taken largely for granted that we went through the S&L crisis, a stock market crash of similar magnitude to 1929, and the Soviet currency crisis in the 1980’s; and the Asian financial crisis in the 1990’s without a Great Rescission or Great Depression. But all of these had the potential to rock our world much the same because markets are tightly linked; flight to safety comes here and destabilizes our economy – if the central bank doesn’t accommodate it. NGDP can collapse just from demand for liquidity in crises that don’t originate here.

It doesn’t matter if housing starts peaked in 1926 after a sharp increase or if the stock market crashed in 1929. The only thing that makes these different than the crises I listed above is what the central banks did about them. A housing bust did not cause the Great Depression nor did the 1929 stock market crash. These might have caused a recession as reallocation takes place, but monetary mismanagement morphed the recession into the depression by allowing NGDP to collapse just as monetary mismanagement morphed the housing and oil shock recession into the Great Recession by allowing NGDP to collapse in July of 2008.

It is very difficult to separate causality with one bad thing seemingly leading to another and they are plausibly linked, but there is only one thing that can cause a massive economic collapse where the problems go bleeding out across all sectors of the economy, and that is issues with monetary policy. Supply-side issues don’t cause tent cities and mass unemployment across sectors unless they are as large and sweeping as NIRA; and even NIRA needed help from the Fed to be as destructive as it was.

I did a post a while back called “The Bernanke Legacy”. In it I feature videos that document the cost of the Great Recession. A few of them are from my hometown, Riverside, CA, where I lived until I was 26. Some of the things in these videos are quite shocking, as I have never seen anything like the privation they capture – except in photo documentaries of the Great Depression. Southern California is a very special place economically; at least it was when I left it 18 years ago. I never had problems finding a job, even during a recession, and I wasn’t particularly educated or experienced in anything other than accounting at the time. If you’ve seen these, it probably goes without saying that for that place to be hit hard, things have got to be really bad.

Of course where I am now, in a suburb of Rochester, NY, we didn’t have tent cities; but Rochester isn’t a rockin’ place like Southern CA. I did, however, “feel” the crash in the summer of 2008. The ordinarily busy streets became deserted and the business zones and malls were like ghost towns. I felt a little like I was living an episode of the twilight zone and I was the last living human being on earth. I have never seen anything like it.

Some people have said the housing bubble popping was so big that having the expectation that the Fed could have prevented the financial crisis is unrealistic. I don’t agree. If the Fed had done what it is doing now, buying MBS at $40B per month, it would have kept that market from collapsing. It isn’t even moral hazard because the Fed’s job is to keep instability from spilling over into the wider economy and to prevent the very thing that happened – collapse of the financial system and NGDP. An ounce of prevention is worth a pound of cure; to keep people from needlessly losing their jobs and everything else they’ve spent their lives building because those things take a very long time to rebuild.

But even that isn’t that great of an explanation because what happened is more involved. The basic problem that can be seen from the FOMC meeting minutes in 2006 though 2007 is that there was some hysterical concern about inflation from oil prices (there is even mention in one of them about cost-push issues!!). And we know from basic macro textbooks that we shouldn’t be trying to adjust monetary policy to compensate for headline inflation coming from volatile energy issues. I can only speculate that the primary reason they were worried about it is the confusion involved with the concept of inflation targeting, and they tightened to compensate for inflation from oil prices which started slowing the economy down. Reading through all of the minutes, one can get a sense of panic toward the end of 2007, that perhaps they were too aggressive in “firming” policy and they started lowering interest rates. It doesn’t say it in the minutes, but I believe the Fed stopped lowering rates @ 2% in early 2008 because they hoped that would be enough given the possibility of lower bound, with concern that more inflation was still a risk. By the time the Fed lowered rates to near zero, at the onset of the financial crisis in the fall of 2008, the damage to markets and the economy had already been done.

So we can see some mistakes in tightening prior to the housing crash. And then we can see failure to recognize the cause of banking stress and alleviate it before it grew into a monster, in addition to failing to accommodate flight to safety as the exchange rate skyrocketed and bond yields plummeted. These errors of commission and omission are what turned the housing crash into an economic collapse. What has prolong it is the feet dragging while trying to manage inflation at the ZLB. Never mind that inflation is at historic lows and that the target has been missed ever since the collapse – if it’s below target, that’s good enough for the FOMC and too darned bad for people losing a job and livelihood.

I don’t really mean to be so long-winded here, but it annoys me when people like Evan Soltas who should know better than to correlate housing in the 1920’s with the 2000-era crisis as if it represents some commonality in cause. It’s highly misleading and contributes to confusion and obfuscation of the real problems we face. Evan, stop feeding the trolls – educate – not obfuscate.

HT: Scott Sumner

PS: It has gotten very late while I was writing and editing this piece. I will add links in a later update.

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