Why does economy fall to pieces after a financial crisis

This is the title of a new paper by Robert Hall in the latest issue of Journal of Economic Perspectives.

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses. Less conspicuous has been the macroeconomists’ concern about  why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis. This article pursues modern answers to that question. It focuses on events in the United States since 2008.

Existing macroeconomic models account successfully for the immediate effects of a financial crisis on output and employment. I will lay out a simple macro model that captures the most important features of modern models and show that realistic increases in financial frictions that occurred in the crisis of late 2008 will generate declines in real GDP and employment of the magnitude that occurred. But this model cannot explain why GDP and employment failed to recover once the financial crisis subsided—the model implies a recovery as soon as financial frictions return to normal. At the end of the article I will mention the ideas that are in play to explain the persistent adverse effects of temporary crises, but these ideas have not made their way into the mainstream model.

A nice paper which summarises how can one link financial frictions into real economy.  He mentions two frictions – pricing power of firms and unemployment. Much of the thinking is based on old well accepted ideas and it beats me how economists missed this or preferred to ignore the linkages.

As Hall says:

The failing of macroeconomics in the last few years was not a lack of understanding of what happens in the overall economy when a financial crisis strikes. Conditional on a large decline in asset values among financial institutions, we got things right. Instead, the failings lay elsewhere.

First, only a few economists, certainly not including this writer, understood that anything that went as high as real-estate valuations in 2005 would have to come down at some point.

Second, many macroeconomists failed to foresee a financial crisis as the situation evolved after 2005 because financial markets had handled the huge decline in asset values in 2000–2001 so smoothly. We overlooked the key point
that the assets in decline in that episode were business assets, mainly in a sector, high-tech, that uses little debt finance and thus has little leverage.

By contrast, the other important asset class in the U.S. economy, real estate, has high leverage everywhere. Most homeowners borrow as much as they can when buying a house; they become unlevered only if they remain in the house and pay down the mortgage. In the 2000s, borrowing as much as you could meant borrowing close to the entire price of the house. The story of the multiple added levels of leverage among financial institutions holding real-estate-related assets has now been told many times. Thus, the economy is severely at risk from even a small decline in real-estate values—following literally the Bernanke, Gertler, and Gilchrist (1999) script—while it is little affected by even large declines in the values of non-real-estate business assets.

He points to couple of areas which make for interesting research ahead.

  • Why don’t companies lower wages n times of such high unemployment? In others words, unemployment could be lower of companies bargain for lower wages and add more people in payrolls
  • Why consumers prefer to save rather than spend in such times? Now models will look at income uncertainty and lower ability to borrow as factors for this behavior
  • Policy design is an exciting area where macroeconomists join hands with financial economists to understand role of debt. Then design policies for good and bad times
  • Zero bound rates continues to remain a mystery  as so much work remains in that area.

Nice crisp paper.

2 Responses to “Why does economy fall to pieces after a financial crisis”

  1. “human genome sciences”: Stocks on the move: D.R. Horton, Regions Financial, Wesco | RedHotNews.org Says:

    […] Why does economy fall to pieces after a financial crisis « Mostly … […]

  2. Krsyithent Says:

    Is a very well written post….. Thanks so much for information. ….Sorry for my English

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