5 Years Later: The Crisis We Averted and the One We Didn’t

Brad DeLong recently wrote an excellent piece contrasting the “Banking Versus Macroeconomics” camps in assessing how the U.S. responded to the financial crisis that peaked with the uncontrolled bankruptcy of Lehman five years ago. A quick summary:

One camp, call it the Banking Camp, sees a central bank as a bank for bankers: its clients are the banks…and its functions are to support the banking sector and …to ensure that there is enough credit and liquidity in the economy that mere illiquidity rather than insolvency does not force banks into bankruptcy and liquidation. 

Another camp, call it the Macroeconomic Camp, sees a central bank… as the steward of the economy as a whole, with its primary responsibility not to preserve the health of the businesses that make up the banking sector but rather to maintain the health of the economy as a whole.”

This is a useful dichotomy, and one that can help explain differing assessments of how policymakers responded to the Global Financial Crisis of 2007/08.

From a Banking perspective, the response has been extraordinarily aggressive and successful. Most large incumbent financial institutions were preserved without wiping out shareholder equity, the extraordinary distress in financial markets was generally short-lived, with credit conditions easing up significantly by the middle of 2009. And financial sector salaries and profits are growing healthily again.

From a Macroeconomics perspective the mission is clearly not accomplished. Four years after official recovery from the Great Recession was declared, key macroeconomic aggregates like the output gap and the share of prime-aged workers who are employed have basically recovered only a third of the way to pre-recession health.

Are those in the Banking camp just simple Wall Street shills? Some, certainly. But some, I would argue, are just missing the fact that we really had two economic crises in the past five years—one was a financial crisis and the other was a macroeconomic crisis brought on by the destruction of aggregate demand.

Both crises were caused by the burst housing bubble. The decline in prices degraded the value of mortgage loans that were the basis of mortgage-backed securities, and since these securities are key assets in the financial system, the financial crisis was born. The decline in home prices also reduced household wealth—and a long history of economic research indicates that every $1 in lost housing wealth results in roughly a nickel to a dime in reduced spending. This is easily enough to spur a recession, and its knock-on effects of reduced home-building, reduced state and local tax revenues and spending, and reduced business investment as customers dry up all add up to our macroeconomic crisis.

It is true that in the past—particularly during the Great Depression—episodes that started as financial crises were mismanaged and blossomed into macroeconomic recessions (or even depressions). The main way this happened was that inappropriately restrictive monetary policy (in part driven by misguided desires to defend the gold standard) combined with cascading bank failures to starve the U.S. economy of liquidity. Sources of short-term working loans needed just to pay workers or keep business shelves stocked dried up, and the result was the leveraging of the financial crisis into the Great Depression. In surveying this history, current Federal Reserve Chair Ben Bernanke summed it up as “Regarding the Great Depression. You’re right, we [ie, the Fed] did it. We’re very sorry. But thanks to you, we won’t do it again.”

And at least on this, U.S. policymakers delivered. The financial crisis was not allowed to explode the rest of the economy, because policymakers were extraordinarily aggressive in containing it. One can argue we could have kept the financial crisis contained while also being much harder on incumbent financial market players (something I firmly believe), but it is true that we actually did not have a Great Recession that was driven by financial sector developments that were amplified and spilled over to the rest of the economy.

But we did, of course, have a Great Recession—the one driven simply by the effect of the bursting bubble on household wealth and from which we remain far from recovered. And while the beginning of it was characterized by great urgency and efforts to fight it, including the American Recovery and Reinvestment Act, since then the response has been abysmal, mostly because Republicans in the House of Representatives have managed to smother efforts that would have helped. Most sadly, their success in smothering efforts to help have been so successful that even the Obama administration now barely mentions the need to do more to spur a full recovery. Instead they largely accept applause for recent large declines in the deficit (which are in part just another way of saying “austerity”) and argue for the sequester to be replaced with, at least in part, more-surgical spending cuts.

All in all, the last five years saw us keep the financial crisis safely contained, largely by shoving money into the pockets of the same incumbent financial market players who help lay the tinder for the crisis, but has also saw us give up fighting the economic crisis far too prematurely. This is not a happy anniversary.