Economics, Monetary Policy, Pethokoukis

Did the housing crash cause the Great Recession? No, it was the Fed

Image Credit: Medill DC (Flickr) (CC BY 2.0)

Image Credit: Medill DC (Flickr) (CC BY 2.0)

Just as the 1929 stock market crash didn’t cause the Great Depression, the housing collapse didn’t cause the Great Recession. In both cases, monetary policy mistakes were the likely proximate and fundamental cause. The role of the Federal Reserve in the Great Depression was the subject of Milton Friedman and Anna Schwartz’s A Monetary History of the United States. The Fed’s role in causing the Great Recession and Financial Crisis is explained in The Great Recession: Market Failure or Policy Failure? by Robert Hetzel. The first book caused a major rethink in the economic profession, so should the second. As Hetzel puts it: “Restrictive monetary policy rather than the deleveraging in financial markets that had begun in August 2007 offers a more direct explanation of the intensification of the recession that began in the summer of 2008.”

I have written a number of blog posts on this topic. But Ramesh Ponnuru gives a great overview on the theory in his wonderful new National Review story, “Cause for Depression.” Although the housing slump began in mid-2006, the economy actually weathered the decline quite well until 2008. The following two charts show housing prices and starts vs. the unemployment rate:



Ponnuru picks up the story:

One way monetary policy affects the economy, and arguably the crucial way, is by shaping expectations. When the Fed creates an impression about future spending levels, it affects the spending that people undertake today in anticipation of that future. So when the Fed suggests that it will pursue a tighter policy in the future, it is effectively tightening money in the present. Even when it cuts the federal-funds rate, it may be tightening money if markets had projected a sharper cut.

By mid 2008 the Fed had been effectively tightening for months. In December 2007 the Fed cut the federal-funds rate by less than markets had expected. During the summer Fed officials made inflation-phobic comments that led informed market participants to expect a tighter policy in the future. The minutes of the August 2008 meeting declared that “members generally anticipated that the next policy move would likely be a tightening.” Current policy was “passively” tightening as well: As the economy deteriorated, the distance between the looseness it needed and what the Fed was providing increased.

Even after Lehman Brothers collapsed in September 2008, the Fed refused to cut the federal-funds rate and issued a statement citing the risks of inflation. Market expectations of inflation fell further. The Fed would not cut rates until October 8, weeks after the crisis had started to dominate the news — and even that decision followed a contractionary move, the October 6 decision to pay banks interest on excess reserves, which discouraged bank lending.

Markets had no reason to have any confidence that the Fed would continue to keep total spending throughout the economy rising at a steady rate, as it had more or less done for the previous quarter-century. Indeed, spending started to fall in June 2008, months before Lehman’s collapse, and ended up declining at the fastest rate since “the recession within the Depression” of 1937–38. Tight money — that is, reduced expectations of future spending — made everything worse. It depressed asset prices and raised debt burdens, adding to bank losses and making households more fearful about spending.

Which is why some folks call the Great Recession “Bernanke’s Little Depression.” While the Bernanke Fed should get much credit for being as active as it was once the economy collapsed — especially compared to the European Central Bank — it could and should have done more, as Ponnuru adds: … “very tight money led first to a financial crisis and then to a slow recovery.”

Now, this is an extremely inconvenient narrative for those blaming the Great Recession on a free-market failure as a way of pushing for more government regulation and control in all aspects of the economy. And while it may also be how most Americans view the Great Recession, pro-market advocates should nevertheless try and set the record straight.

12 thoughts on “Did the housing crash cause the Great Recession? No, it was the Fed

  1. You’re not a “pro-market advocate” if you think current crap economy is the result of not enough government intervention.

    The Fed caused — alongside a variety of inane federal policies — the housing bubble; the subsequent slow economy would actually have been much worse had it not been for the artificial growth simulated by the torrent of money printing. In other words, this post is 100 percent the opposite of reality.

    The Great Depression mirrors today’s situation almost perfectly: Central banks manufactured a boom; when the crash came, the feds over-reacted and rather than let market dynamics resettle, they tried propping up the pre-existing economy, which only prolongs the pain. There has been so many useful things written about the Great Depression. It’s a shame the author has apparently not read any of them.

    • what killed the economy was when all the margin calls were made and so many had to sell stocks right away, taking pennies on the dollar (bought up by the elites who caused the mess) and with nobody with money, nobody could purchase things so people were laid off and it all escalated (kind of like Europe’s recent attempt at “austerity”)

      • Real estate is a super inefficient market. When I started shopping for land in the summer of ’08, I couldn’t find any sellers who felt urency outside of ground-zero neighborhoods in the Washington DC suburbs. Real estate agents finally understood what was coming after Freddie and Fannie failed that fall, but sellers still wanted the price the Joneses down the street got in 2006. Today, if you stopped a hundred people on the street, I doubt that five could tell you what the Case Schiller index is,
        So chart unemployment against an obvious real estate indicator, like foreclosures, and both peak in 2010. A weak housing sector stiill hurts today, being one of those industries that can’t be offshored.

  2. They both caused it.

    Government created a massive housing bubble via multiple misguided policies (most of which are still in place), and the Fed helped with low rates.

    It needs to be mentioned, however, that a significant portion of “flippers” and housing “investors” contributing to the bubble were almost completely rate-insensitive, and didn’t care what rates were because they wouldn’t hold properties for longer than 6 months. They could count on that due to lax lending standards, and government incentives to create those loans.

    • Dubuque IA was largely flipper free but had plenty of trouble anyway because of cash-out refis. Regional busts are commonplace in history — ND is working on the classic resource-based kind at this moment. (Only $89,900 for a 1975 mobile home; snap up this creampuff now!) But no one, from Greenspan to board members at the First National Bank of Possumtown (MD), believed that housing prices could collapse nationally.

      Here, in an otherwise excellent primer on real estate’s outsized impact on the economy, is an AEI fellow in ’06 handicapping the odds of a housing led recession at one in two.

      Bankers were in a much better position to see it coming, and to me, affordability is the immutable limit on housing prices. One guesses, that even around the boardroom table in Possumtown, the loan committee was thinking we better grab this one before Countrywide does.

      • Bankers had no immediate reason to “see it coming,” and the incentive to create more bad loans was overwhelming.

        The ultimate constraint on real estate transactions is bank willingness to lend, and that is primarily determined by lending standards, and diktat (CRA, etc.).

  3. I have a hard time buying into the notion that by cutting already historically low rates to even lower rates, but not as low as expected is somehow “tight” monetary policy.

    This whole crisis was perpetuated by too much loose money.

  4. This gives the impression that the mis-functioning financial system played no part, which we know is not the case. The bubble in housing was encouraged by Federal Government and masive Gov’t guarantees were implied? Lenders were this ‘incentivised’ into bad lending, securitization – a system worth having providing originators are forced to retain ‘skin in the game’ – became the route to shuffling bad loans to government agencies, and interest rate policy in 2002-06 failed to recognize what the reality was.

    As did Bernanke in 2007-08. Everyone, including borrowers played a part. The Fed was caught up in the hubris along with the herding in the markets.

    It will happen again however you write the rule book. The worst part is that Federal institutions were key players. The rest were bound to follow their lead. Wisdom cannot be legislated for or implemented by regulation….

    • The thing about perverse incentives is that they are voluntary. No one forced mortgage brokers to originate liar’s loans even if syndication made them someone else’s problem. No one forced Wall Street to underwrite those syndications even if they passed the problem along to investors. Finally, no one forced bond investors to buy MBS paper. Jim Cramer was saying in 2007 that EVERY mortgage written in 06 or later — predominantly refis — would end up under water. But, hey, the govt can’t let Fannie and Freddie fail, and agencies pay a premium rate so what the hell. (What people miss, even now, is that an accommodative Fed creates slim pickings in fixed-income investing.)

      So if the cause of the housing bust was govt programs that left money laying around, a simple solution would be, you know, stop taking it,

    • Ian Campbell
      Interesting name. But why was there a mirror “bubble” in commercial real estate that allso popped in 2008?

      That suggests a macroeconomic root..althiugh I would prefer the government get out of housing…but leave in the home mortgage tax deduction…

  5. Ridiculous post. The Fed does not control the money supply. Money is endogenous, and all the Fed can do is influence interest rates.

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