The “Great Recession”: Economic Crisis & Crisis in Economics

Sasan FayazmaneshOctober 11, 2012

Summary

This presentation deals with the US economic crisis that began in 2008, as well as the crisis in economic theory.

It is argued that while the recent crisis was not a depression and hardly comparable to the Great Depression, it was a “Great Recession.”

Moreover, the Great Recession brought to the fore the underlying crisis in economics.

See Paul Krguman, End This Depression Now! 2012

In particular, I will look at:

• The rate of growth of GDP, unemployment rate and bank failures since the beginning of the crisis

• The timeline of the crisis

• The problem of causation and economic theory

But before all this:

“Economics 101”

Q: What is the difference between a recession and a depression?

GDP

Historical Time

Recession(2 quarters decline in GDP)

Business Cycle (Trade Cycle)

GDP

Historical Time

Depression!(A “severe” recession)

Long Waves (Kondratiev waves)?

The Great Depression (1929-1939)

By 1933: 

1) There was no new investment

2) GDP was down by 1/3

3) Unemployment was at 24%

4) Nominal wages and prices were down by 1/3 5) The banking system collapsed, after nearly 11,000 banks closed in the US (40% of all banks)

6) Stocks lost 90% of their values

Q1: Was the downturn in 2008 the beginning of a depression?

Q2: Are we currently in a recession?

2007q4 14,253.2 13,326.02008q1 14,273.9 13,266.82008q2 14,415.5 13,310.52008q3 14,395.1 13,186.92008q4 14,081.7 12,883.52009q1 13,893.7 12,663.22009q2 13,854.1 12,641.32009q3 13,920.5 12,694.52009q4 14,087.4 12,813.52010q1 14,277.9 12,937.72010q2 14,467.8 13,058.52010q3 14,605.5 13,139.62010q4 14,755.0 13,216.12011q1 14,867.8 13,227.92011q2 15,012.8 13,271.82011q3 15,176.1 13,331.62011q4 15,319.4 13,429.02012q1 15,467.8 13,491.4

Year Nominal GDP ($B) Real GDP ($B)

Source: US Department of Commerce: http://www.bea.gov/national/index.htm#gdp

5.1%

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual

2005 5.3 5.4 5.2 5.2 5.1 5 5 4.9 5 5 5 4.9 5.1

2006 4.7 4.8 4.7 4.7 4.6 4.6 4.7 4.7 4.5 4.4 4.5 4.4 4.6

2007 4.6 4.5 4.4 4.5 4.4 4.6 4.7 4.6 4.7 4.7 4.7 5 4.6

2008 5 4.9 5.1 5 5.4 5.6 5.8 6.1 6.1 6.5 6.8 7.3 5.8

2009 7.8 8.3 8.7 8.9 9.4 9.5 9.5 9.6 9.8 10 9.9 9.9 9.3

2010 9.7 9.8 9.8 9.9 9.6 9.4 9.5 9.6 9.5 9.5 9.8 9.4 9.6

2011 9.1 9 8.9 9 9 9.1 9.1 9.1 9 8.9 8.7 8.5 8.9

2012 8.3 8.3 8.2 8.1 8.2 8.2 8.3  8.1  7.8        8.2

Unemployment Rate

Source: US Department of Labor: http://data.bls.gov/timeseries/LNS14000000

Year %

1979 5.8

1980 7.1

1981 7.6

1982 9.7

1983 9.6

1984 7.5

1985 7.2

1986 7.0

Unemployment Rates in the 1980s Recession

Source: US Department of Labor: http://www.bls.gov/cps/prev_yrs.htm

Bank Failures Per Year

2006 0

2007 3

2008 25

2009 140

2010 157

2011 92

2012 NA

Sources: FDIC: http://www.fdic.gov/bank/historical/bank/2006/index.html

The average number of bank failures in the 1930s: 2000/year

Q1: Was the downturn in 2008 the beginning of a depression?

A: No!

Q2: Are we currently in a recession?

A: Technically, no!

However, the 2008-09 recession was one of the most severe recessions since the Great Depression.

It was a “Great Recession”!

Q: How did the “Great Recession” of 2008-09 start?

What was the timeline?

Partial Timeline ( Federal Reserve Bank of St. Louis):

•4th quarter of 2007: Downturn in GDP (according to National Bureau of Economic Research, the recession began in December of 2007)

• January 2–21, 2008: stock market downturn

•January 22: The FOMC votes to reduce its target for the federal funds rate 75 basis points to 3.5 percent

•January 24: The National Association of Realtors announces that 2007 had the largest drop in existing home sales in 25 years

• March 10: Dow Jones Industrial Average at the lowest level since October 2006.

• March 24: The Federal Reserve Bank of New York announces that it will provide term financing to facilitate JPMorgan Chase acquisition of bankrupt Bear Stearns Companies Inc.

• July 11: IndyMac Bancorp is placed into the receivership of the FDIC.

• July 13: The U.S. Treasury Department announces a temporary increase in the credit lines of Fannie Mae and Freddie Mac.

• July 17: Major banks and financial institutions that had invested heavily in mortgage backed securities report losses of approximately $435 billion.

• September 7: The Federal Housing Finance Agency places Fannie Mae and Freddie Mac in government conservatorship

• September 15: Bank of America announces its intent to purchase Merrill Lynch for $50 billion

• September 15: Lehman Brothers Holdings Incorporated files for Chapter 11 bankruptcy protection

• September 16: The Federal Reserve Board authorizes the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG)

• October 3: President Bush signs the Emergency Economic Stabilization Act, creating a $700 billion Troubled Assets Relief Program (TARP) to purchase failing bank assets

• Etc.

Note: Such sequences of events had appeared before. For example:

• The “Rich Man’s Panic” of 1907• The Great Depression of 1929-1939

Q: We know the timeline, but what caused the crisis?

Some common answers:

•Mortgaged backed securities, particularly those associated with subprime mortgages; •The housing market bubble, which was made worse by predatory, risky and careless lending; •Exotic financial instruments or derivatives that were allegedly devised by some wunderkind mathematician or physicist on Wall Street, e.g., collateralized debt obligation and credit default swaps; •The events of September 11, 2001, the subsequent US invasion of Iraq and increase in oil prices; •Irrational exuberance in the stock market followed by a bear market;

• The Federal Reserve’s repeated reduction in the discount rate and fed funds rate in 2001-2003;

• The wrongheadedness of the chairman of the Federal Reserve, Mr. Alan Greenspan, who found himself in a “state of shocked disbelief” to learn that “the self-interest of lending institutions” might not “protect shareholders’ equity”;

• Deregulation of the banking industry (doing away with Glass-Steagall Act), particularly the Financial Services Modernization Act of 1999 or Gramm-Leach-Bliley Act;

• Fraud, corruption, high salaries of CEOs, self-serving economists, etc. (see, for example, “Inside Job”).

My answer:

While each of these explanations, or a combination of them, might have some merit, they are mostly after-the-fact explanations (post hoc ergo propter hoc).

We don’t know what caused the economic crisis that began in 2008 (a “perfect storm?”).

We still don’t know what caused the “Great Depression”!To be explained under “Crisis in

Economic Theory””

Q: Why don’t we know?

A: Because the existing schools of economic thought are incapable of explaining such crisis.

This holds particularly for the “neoclassical school,” which is dominant economic theory.

But it also holds for other schools, such as the Keynesian school.

It even holds for the Marxian school.

To be explained under “Crisis in Economic Theory””

Crisis in Economic in Theory

What Caused the Great Depression?

Some common answers:

1) The stock market crash in 1929,

2) The banking panics and monetary contraction,

3) The protectionist policies pursued by the US government—such as the Smoot-Hawley Tariff,

4) The actions of the Federal Reserve, which allowed a decline in the money supply partly to preserve the gold standard. See, for example, “Great Depression,” Christina D. Romer, December 20, 2003:http://elsa.berkeley.edu/~cromer/great_depression.pdf

All such explanations are, of course, ad hoc.

To this day there is no consensus among economists as to what caused the severe depression that lasted from 1929 to 1939.

“Neither contemporary forecasters nor modern times-series analysts could have forecast the large declines in output following the Crash [of 1929].”

(Kathryn M. Dominguez, Ray C. Fair and Matthew D. Shapiro, “Forecasting the Depression: Harvard versus Yale,” The American Economic Review, Vol. 78, No. 4 (September, 1988), pp. 595-612.)

The best economic “brains” of the 1920s, the so-called experts, could neither foresee the coming disaster nor predict correctly its magnitude and duration.

The comments of some of the “experts” right before and

after the stock market crash of October 24, 1929

See, The Experts Speak: The Definitive Compendium of Authoritative Misinformation, Christopher Cerf and Victor Navasky, 1984

 The well-known neoclassical economist and monetary “expert,” Irving Fisher, makes the following predictions about the stock market: 

October 17, 1929 (7 days before the crash): “Stocks have reached what looks like a permanently high plateau.”

 November 14, 1929: “The end of the

decline in the stock market will... probably not be long.”

 A year after the crash: “For the future,

at least, the outlook is bright.”  

Other financial experts had similar outlooks and predictions

For example, the presidential advisor Bernard Baruch writes on  November 15, 1929: “Financial storm has definitely passed.” Chairman of the Continental Illinois Bank of Chicago writes on 

October 24, 1929: “The crash is not going to have much effect on business.”  

The World Almanac of 1929 writes: 

“The Market is following natural laws of economics and there is no reason why both prosperity and the market should not continue for years at this high level or even higher.”

Why the existing schools of economic thought are

incapable of explaining crises?

The Neoclassical or Marginalist School

•This is the dominant school of economic theory

•It is a-historical theory that starts not with analyzing any real economy, but with certain concepts in mathematical physics.

•A “market” consists of two lines!

A “Market”

p (price per unit)

Quantity

Supply

Demand

pe

Qe

• All market are “self-adjusting”

• Left alone, they correct themselves and reach equilibrium

• Laissez faire is the name of the game.

• This holds for the “labor market” and “capital market”

Labor market

W (real wage)

Quantity of labor

Supply of labor

Demand for labor

we

Le

Capital market

i (real interest)

Quantity of capital

Supply of capital

Demand for capital

ie

Ke

In the neoclassical world:

•Neither fiscal policy nor monetary policy can change the “real variables.”

•Deficit spending results in higher nominal interest rates.

•Expansionary monetary policy results in higher prices. There is actually no need for money in this world, money is a “veil.”

The Keynesian School

Keynes clearly saw the incompatibility between the neoclassical theories and the real world, particularly during the Great Depression.

He criticized certain laissez faire aspects of these theories and ultimately advocated for fiscal and monetary policies.

Yet, Keynes was educated in the same neoclassical school and his criticism of these theories was halfhearted .

A few critical notes at the beginning of The General Theory of Employment, Interest and Money (1936) were followed by some theories that were incomplete, underdeveloped and ambiguous.

The result was the “neoclassical synthesis,” a combination of the old-fashioned neoclassical theories, called microeconomics, and Keynesian theories, called macroeconomics.

The ambiguities left in the General Theory has also allowed for various kinds of “Keynesians.”

The Keynesians are at odds with one another as to how high the deficit can go or what steps the Federal Reserve System should take.

They disagree over such matters as how much regulation the financial sector of the economy needs.

Yet, all Keynesians, similar to Keynes, believe in saving capitalism from itself; reform, and not revolution, is their aim. 

The Marxian School

The Marxist economists believe in revolution and not just reform. 

For these economists a little more or a little less deficit spending, or tinkering with the money supply, will not solve the long-term problems of capitalism.

Financial woes of the capitalist economy cannot be solved by more regulation. 

Marxian economics, following Marx, does indeed have crises theories.

In his Capital Marx had two theories of crisis, one cyclical and another secular.

Neither of these theories, however, can explain the Great Recession of 2008.

In sum, none of the prevailing economic theories provide a viable option for understanding and dealing with the Great Recession.

That is why I am waiting for new ways of thinking and new economic theories!