On August 9, 2007, the French Bank BNP Paribus halted redemptions to three investment funds active in US mortgage markets due to severe liquidity problems, an event that many mark as the beginning of the financial crisis. Now, just over seven years later, economists still can’t agree on what caused the crisis, why it was so severe, and why the recovery has been so slow. We can’t even agree on the extent to which modern macroeconomic models failed, or if they failed at all.
The lack of a consensus within the profession on the economics of the Great Recession, one of the most significant economic events in recent memory, provides a window into the state of macroeconomics as a science.
First, on the disagreements. If you ask macroeconomists what caused the crisis, you will get different answers. Some will argue it was lack of regulation of the financial sector, others will cite the buildup up of household debt driven by stagnating middle class incomes. Still others will argue the Fed was at fault for holding interest rates too low for too long and fueling the housing bubble. You will also hear that it was a case of financial innovation gone awry – it failed to deliver on a promise of reduced and dispersed risk for mortgage based financial products.
Even stories that have been thoroughly debunked are still cited by some, for example the argument that it was all caused by government’s attempt to increase homeownership among lower income households. Some of these causes are cited together, e.g. low interest rates could help to encourage household debt accumulation, and it’s possible that more than one factor was at work, but there is quite a bit of disagreement among economists about the primary, most important cause(s) of our troubles.
Economists also disagree about why the crisis was so severe. Is it because of the tremendous loss of wealth that households experienced when the housing market crashed, or is it because of the meltdown in the financial sector, particularly what happened after Lehman Brothers was allowed to fail?
One group of economists argues that the crisis would have been just as bad even if the financial sector hadn’t had such severe problems, the loss of household wealth is the key to understanding why this was a “Great” as opposed to an “ordinary” recession. Others, however, cite problems in the financial sector as essential to understanding why the economy had such severe difficulties.
And when it comes to explaining why the recovery has been so slow, there is also – surprise – little agreement. Some economists argue that recovery from financial crisis always takes a long time. These are “balance sheet” recessions, and it takes time for households to replace what was lost when housing equity disappears and financial markets crash. In the meantime, consumption, and hence aggregate demand, is reduced.
Others argue the slow recovery is due to government regulation standing in the way of business, uncertainty over future monetary and fiscal policy, or the existence of social programs that encourage people to stay unemployed for extended periods of time. In addition, fiscal policy that worked against the recovery is also cited. You will even here that the recovery is not actually so slow if you consider that we are climbing out of a very deep hole.
The considerable lack of agreement on these issues is of concern for three reasons. First, it makes it difficult to design regulatory policies that will avoid similar problems in the future. If we don’t know for sure what caused the crisis, how do we insulate against it? We can take a broad-spectrum approach and close every possible way a crisis could occur, but that risks imposing unnecessary constraints on economic behavior.
Second, it makes it harder to know what types of monetary and fiscal policies work best to fix these types of problems. If we can’t agree on the cause of our problems, and how it worked its way through the economy, we won’t be able to figure out what types of policies are most effective.
As it stands, there are economists who believe that both monetary and fiscal policy should be used to fight deep recessions, others who think only monetary policy should be used, and still others who think government should simply get out of the way as much as possible and do nothing. And within each group there is quite a bit of difference as well, e.g. whether to use government spending or taxes, or, as another example, the type of target the Fed should pursue.
Third, and this gets at the state of macroeconomics as a science, we won’t be able to determine what types of theoretical models work best. How do we sort one model from the other if we cannot agree on what the evidence says?
Why can’t we agree? How is it possible that there are so many different views among economists about the type of shock we experienced, how it was transmitted through the economy, and why it’s been so hard to recover? One reason is that most of the time our macro econometric models do not give answers that are clear enough to settle questions – the non-experimental nature of the data we are forced to use in carrying out tests makes the search for precise answers very difficult.
Even when the econometric models do give clear answers, those answers are often ignored in the public debate over these issues. This is due, in large part, to economists who are willing to ignore clear empirical evidence in order to sow confusion and promote ideological goals, and the culture within the profession that does little to penalize such behavior.
If we don’t have the ability to settle debates decisively with empirical evidence, then each side will retain its beliefs and preconceptions. Perhaps “big data” and digital technology will help, but it’s hard to foresee these problems going away anytime soon. What we can do is change the professional culture that allows some economists to create confusion for political reasons through distortions and misrepresentations of the evidence that does exist.
For example, many of the explanations of the crisis listed above are based upon ideological underpinnings as much as actual evidence, or ignore the evidence altogether. We can’t stop the charlatans and cranks from speaking out, but we can do a much better job of labeling them as such when they do.
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