The fantasy world of conventional central bankers where money has no role

Lawrence Christiano writes “The Great Recession: A Macroeconomic Earthquake”. The summary reads:

The Great Recession was particularly severe and has endured far longer than most recessions. Economists now believe it was caused by a perfect storm of declining home prices, a financial system heavily invested in house-related assets and a shadow banking system highly vulnerable to bank runs or rollover risk.

It has lasted longer than most recessions because economically damaged households were unwilling or unable to increase spending, thus perpetuating the recession by a mechanism known as the paradox of thrift. Economists believe the Great Recession was not foreseen because the size and fragility of the shadow banking system had gone unnoticed.

Not a single reference to money or monetary policy in the whole text!

Does the “perfect storm” argument for the severity of the recession – the reason it is called “Great” – stand up to scrutiny?

I´m doubtful. The chart illustrates.

Three quarters into the recession, real output held up quite well, receiving the bronze medal.

Remember that house prices peaked in early 2006. In early 2007 the financial system, in particular mortgage lenders, were showing stress. Early August 2007 is deemed the “start date” of the financial crisis, triggered by the closing of three Bank Paribas funds. Nevertheless, despite the “perfect storm”, the recession was quite “gentle” up to that point!

Let us peek at what transpired thereafter:

At the time that in many other cycles real output was beginning to recover, for the 2007 cycle that was the moment the recession deepened!

From an “auspicious” start to a “sickening” conclusion, the Fed´s monetary policy was mostly responsible.

The next charts show how monetary policy went from “hesitant”, but strong enough to sustain real output, to downright “obnoxious”, where monetary policy is reflected in the behavior of NGDP (or aggregate nominal spending). (We only show the post inflationary cycles to minimize distortions.)

Moreover, since NGDP remains far below the pre-crisis trend, implying tight monetary policy throughout, real output remains mired in depression, not “Great”, but certainly “Long”.


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