Did the Housing Crash Cause the Recession? No, it Was the Fed


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.

There are 17 comments.

  1. StevenK85 Inactive

    In the summer of 2008, the price of oil was approaching $150/barrel, so fear of inflation was not unwarranted. The inflation from that being realized by the consumer had the countervailing effect of lowering real interest rates, and hurting consumption spending in the months prior to the crash. Neglecting to mention that run up in commodity prices, which the initial cutting by the Fed in 2007-8 fed, seems to be selective history.

    At the same time, I agree about the importance of expectations. Unfortunately, the expectations are set by the same people in the financial industry who benefit most from low rates. And the stock market has repeatedly thrown temper tantrums when they don’t get the easy money they want. The December 07 cut may have been smaller than expected, but following large losses in European markets while the US was closed on MLK Day the next month, the Fed made two substantial cuts within a week.

    I think we are probably in agreement that we would like to see a rules-based monetary policy, and some Fed moves would have been supported by one. But the way the Fed acted both justified

    • #1
    • August 27, 2013, at 1:01 AM PDT
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  2. King Banaian Contributor

    I was going to post on the Ponnuru article today, but it’s first day of the school year here. Let me digest what Jim’s said before writing something more, but I think Bernanke would point Ramesh to his AEA speech from January 2010

    … the relationship between the stance of monetary policy and house price appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and greater house price appreciation than the United States.

    The speech also showed that the Fed had erred towards too much ease in 2002-04, was barely tight relative to the Taylor rule in 2006, and that much of the criticism of ease is on the basis of data not in evidence when the Fed made its decisions on monetary policy. So the Ponnuru/Pethokoukis/Sumner argument is an argument contra the Taylor Rule which, while not gospel, was certainly the state-of-the-art measurement of monetary policy ten years ago.

    • #2
    • August 27, 2013, at 1:02 AM PDT
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  3. StevenK85 Inactive


    and led to more panic.

    • #3
    • August 27, 2013, at 1:02 AM PDT
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  4. J.Maestro Inactive
    Frozen Chosen: The question then becomes whether or not the Fed did this in an attempt to influence the election in Obama’s favor – something which would not surprise me in the least. · 11 minutes ago

    Come now, you’re implying that we have a government class aristocracy that weighs policy not by the measure of public good but by narrow self-interest.

    After seeing the IRS close ranks around its Dirty Tricksters I’m finding this easier and easier to believe.

    Still, I’m not convinced that monetary policy was the prime move. There was a madness brewing, and the fisc went completely psycho with the 2006 election. Property rights and contract rights were the playthings of politicians — old hat today, but massively unnerving to any sane American watching the Manchurian Candidate climb in the polls.

    We’re used to it now. But we won’t recover fully until property rights, contract rights, and basic economic liberties are fully restored. Do that and it won’t matter how badly you mess up monetary policy — value will out.

    • #4
    • August 27, 2013, at 1:28 AM PDT
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  5. Duane Oyen Member

    I suspect that we will find in the end that the various suspected causes indeed “caused” the economic malaise- the triggers have to get some credit- and that, as Scott Sumner has explained in two EconTalk podcasts, the Fed unwittingly extended and exacerbated it with excessively tight money.

    There were so many instances of bad behavior here that each of the pieces surely contributed.

    • #5
    • August 27, 2013, at 1:31 AM PDT
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  6. Done Contributor

    And again, James blames the popping of the bubble for the downturn, rather than the inflating of the bubble.

    • #6
    • August 27, 2013, at 2:01 AM PDT
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  7. BrentB67 Inactive

    The fed’s hands aren’t clean in this mess thanks to their mandate(s).

    Fiscal policy and legislative interference were bigger drivers of the inflation bubble that Frank notes in #9. If we didn’t have Congress encouraging reckless lending with Fannie/Freddie backstopping all the marginal mortgages so they could be securitized into CMO’s to be leveraged against, sold, re-purchased, and attempted to be hedged with OTC derivatives we wouldn’t have had a housing bubble no matter how loose the FOMC had been following 9/11.

    Would we have had some other kind of bubble somewhere, possibly and oil and gas prices circa 2008 are suspect, but we could’ve avoided the housing bubble who’s demise hit a much more broad cross section of the economy.

    • #7
    • August 27, 2013, at 2:26 AM PDT
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  8. BrentB67 Inactive

    King – great comment. The argument that this was all the Fred’s fault ignores that the loose policy of the early part of the decade was in response to an external terrorist shock – September 11, 2001. I am not sure there is a playbook anyone envisioned that had a better response or any response at all to those attacks.

    • #8
    • August 27, 2013, at 2:51 AM PDT
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  9. John Hanson Thatcher

    So, if only the Fed had been able to make better decisions all would have been well? I doubt it. This is the old example from Plato of Philosopher Kings, and it is always impossible for any individual or small group of individuals to foresee the effects of what they do, especially what always occurs, “unexpected consequences” so the usual result is for “policy” to make things worse, not better. This is why markets work, capitalism works, and other forms fail. If we get government out of the business of deciding winners and losers based on politics, then the economy could grow better. We won’t! so I expect boom and bust to continue. They happen even with markets, but recoveries are usually faster, and busts seem shorter. I tend to think we do not need a Fed.

    • #9
    • August 27, 2013, at 4:28 AM PDT
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  10. Bill Thom Inactive

    Surely a huge part of the recession was the popping of the real estate bubble. There was obviously a bubble, housing prices were soaring well above the historical trend line. Massive borrowing against home equity that wasn’t real fueled huge consumer spending which was driving the economy. As home prices started to fall, people realized their home equity was disappearing and consumer spending began to erode. This coincides precisely with a slow down in GDP and a rise in unemployment.

    The housing bubble was caused in large part due to loose monetary policy, and the popping of the bubble began before the Fed started to tighten. Even if the Fed’s tightening did exacerbate or trigger the bubble implosion, letting the housing bubble continue to grow by overly loose policy was not a good idea. 

    This entire line of reasoning dismissing the housing crisis seems flatly wrong on it’s face to me.

    • #10
    • August 27, 2013, at 4:50 AM PDT
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  11. Late Boomer Member

    I would love to see a study that goes back and adjusts GDP for the mortgage contribution to the economy. Back in 2005, a mortgage broker facilitated a loan and clipped some amount, so did the company he worked for. That income went into GDP, although as a country we just borrowed the money and the payback came out of future earnings. Likewise that money borrowed in a cash-out refi and spent at Home Depot was also put into GDP.Obviously there are first order and second order effects here. Besides the GDP overstatement, there was an allocation of capital to businesses that facilitate consumption. I contend that the early aughts just pulled forward GDP from current times.

    • #11
    • August 27, 2013, at 5:35 AM PDT
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  12. ShellGamer Member

    The comments strike me as far more plausible than “the Fed did it.” The desire to pin the collapse on the Fed to the exclusion of other factors shares with liberalism an unfounded belief in the ability of technocrats to control human behavior and make everything safe for everyone all the time. Markets get things wrong all the time, but they exact immediate punishment on those who make mistakes. Tinkering with this in the name of security frequently increases the overall risk of the market system.

    • #12
    • August 27, 2013, at 7:26 AM PDT
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  13. Profile Photo Member

    Instead of trying to get rid of the Fed, has anyone had the idea that when they (or economists in general) are wrong there should be punishment? Perhaps they would have to choose 10 people for a firing squad or something. No trials, no blame on the gov’t just when certain limits are reached there has to be a sacrifice for playing god by testing theories and playing politics with OPM and doing it badly. 

    You know, make it a more dangerous profession than lumberjack or fireman. 

    • #13
    • August 27, 2013, at 8:12 AM PDT
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  14. Tuck Inactive

    Er, you’re “pushing for more government regulation and control”… 

    Has having the Fed attempt to micromanage the economy really worked all that well? Perhaps we also need a Federal Housing Board to determine how many houses we should build…

    • #14
    • August 27, 2013, at 12:49 PM PDT
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  15. Marion Evans Inactive

    The Fed is partly responsible, but so are Wall Street banks, credit agencies, Congress etc. Historically, the issuer of the mortgage had to bear the risk that the borrower may default. But because the mortgages were sold to the banks which packaged them into CMOs and stuck investment grade ratings on them, the risk was removed from the issuer. These issuers were compensated on the volume and size of mortgages they were issuing, regardless of risk. It was free money and a disaster waiting to happen.

    As to interest rates, long rates (10 to 30 year) were arguably too low in 2005-06 because Chinese buyers of treasuries were pushing rates down, a by product of the yuan-dollar fixed rate. But that’s another discussion.

    • #15
    • August 27, 2013, at 12:53 PM PDT
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  16. Frozen Chosen Inactive

    The question then becomes whether or not the Fed did this in an attempt to influence the election in Obama’s favor – something which would not surprise me in the least.

    • #16
    • August 27, 2013, at 12:54 PM PDT
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  17. Late Boomer Member

    I’m not sure how practical that is Mary, but it is fun to think about. It would sure help in getting our monetary policy off of the PhD standard. What did they used to do to witch doctors and rain makers who failed to increase crop yields or rainfall? After being told, again, that they needed to make more sacrifices to the gods or the shaman’s treasury, did they run the guy out of town on a rail?

    There is nothing new in the world, not even new mistakes.

    • #17
    • August 28, 2013, at 7:15 AM PDT
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