When the Obvious isn’t Obvious

For many observers, it seems obvious that the roots of the current recession lie in the crisis in the banking sector.  In the Economist’s Voice (a non-technical, yet academic, electronic journal), Robert Barbera attacks University of Chicago Economist Casey Mulligan and other real business cycle theorists for having a framework that cannot either predict or even describe important economic phenomena.

Barbera chides for Mulligan for predicting in the Fall of 2008 that we wouldn’t see large decreases in employment because of the weak linkage between the financial sector and the rest of the economy.  Mulligan argued, and still does, that gyrations in the financial sector are not closely linked to performance of the economy overall.  In other words, the obvious is not obvious.

In a sharp response, Mulligan correctly points out that Barbera’s critiques are not based on any theoretical critique of the large literature on this topic, but merely on Mulligan’s incorrect prediction.  Mulligan acknowledges he was wrong, but points out that that obvious story cannot easily account for two important facts.  First, that even though employment fell sharply, GDP and consumption did not.  Second, the massive infusion into the financial sector did relatively little to increase lending.  [It all seemed to go into the monetary base, which caused know-nothings like Glenn Beck to rant about how this was going to cause rapid inflation and financial catastrophe.]

Mulligan does have an alternative account of the current recession.  He thinks it was caused primarily by distortions in the labor market, namely three successive increases in the minimum wage and a mortgage modification program that was associated with an marginal tax rate of over 100%.  He does acknowledge that there might be monetary or capital sector stories that could be explored, but I find the labor market story intriguing.

I’m highly suspicious that the banking sector crisis was completely unrelated to the current recession (and I suspect Mulligan would allow for some role).  But, on the other hand, Mulligan’s argument is based on careful modeling, data analysis, and peer review.  Barbara’s argument is based on huffing and puffing about what is obvious.  Mulligan admits the full story isn’t known, but he is none to kind of the resurgence of Keynesian thinking in the public sector:

Recent events only reinforce the prescription that economic analysis should be rooted in incentives, not voodoo incantations of multipliers and contagion.  But the latter will continue to enjoy prominence in the political marketplace, where there’s nothing like telling taxpayers “Give me your money and, trust me, your gift will make you richer.”

Often when people say something is obvious it means they don’t have a good argument.

Addendum: One of the commentators below references the views of Scott Sumner, who always has intelligent things to say.  In particular, back when Paul Krugman was screeching that we simply HAD to have a giant stimulus because we were in a liquidity trap and therefore out of monetary tools, Sumner wrote a nice little piece in The Economist’s Voice arguing that of course we still had tools.  If you are interested, you can also read my little comment on Sumner and on Brad DeLong’s mischaracterization of our available policy options (DeLong argued that the only way to do deficit spending was to increase spending, neglecting to mention cutting taxes).  It is my simple-minded attempt to be a macroeconomist–something I will avoid in the future, except when blogging!

6 thoughts on “When the Obvious isn’t Obvious

  1. I know just barely more about economics than Glenn Beck, but isn’t it likely that the sharp decrease in employment was caused in large part by a stock market crash in which, as of the end of 2008, about $8.4 trillion in wealth was lost? This, in turn, led companies to tighten up on hiring and bare down on existing employees to be more productive. And so forth.


    1. Plausible, but many economists don’t see a strong link between asset prices and labor demand.

      Say that you are a CEO, you show up at work one day and your stock price has been cut in half. Nothing else has changed: your product is still selling for the same price, your workers cost the same, your rent and expenses are the same. What do you do?

      Now if this happens, you (and most people) would probably freak out. It is not inconceivable that you would fire people, but it is a bit tricky, I think, to make a strong rationalist argument that would happen systematically in the economy as asset prices fall.

      Of course the degree to which the economy is influenced in the short-run by “animal spirits” (i.e., freaking out) can be considerable, perhaps, at least Keynes thought so. But to say that there are animal spirits is a lot different than having a model of animal spirits–which is what lets you make systematic predictions.

  2. I too would be very interested to learn more about Mulligan’s theory. Popular economic writing would have it that the “seizing up” of financial markets in 9/2008 meant less credit for business, which meant less hiring and business investment, causing employment to tumble and GDP to turn negative. (On this last, US GDP growth was pretty negative for the last quarter of 2008 and first two quarters of 2009, wasn’t it?)

    1. According to Mulligan’s numbers the decline in employment was about 4 times the decline in output.

  3. You may be familiar with Scott Sumner’s story of this recession, but I find it to be the most convincing. A (very) brief summary:

    1. Bad private loans, along with Fannie and Freddie, led to the bust in the housing market. This caused a rather minor recession from late 2007 to about October of 2008, concentrated in a few regions.

    2. The FED did not respond appropriately, by essentially giving up when rates hit zero and worrying about inflation when deflation should have been the bigger worry. As Sumner has shown many times, Bernanke’s academic work shows that he knows there are several tools to use when rates hit zero. The massive increase in the Monetary Base did not have an expansionary effect, because the FED paid Interest On Reserves. This is a contractionary policy.

    3. The mistakes by the FED caused nominal GDP to actually shrink for the first time in a long, long time. This exasperated the problems in the financial sector and caused the recession to become much deeper and widespread across the country. As well, several supply-side mistakes by the government, including a higher minimum wage, significantly longer Unemployment Insurance, crackdown on immigration, health care taxes, etc. have made the self-correction mechanism much slower than it need to be. However, the ultimate blame falls on the Federal Reserve’s unwillingness to take action when it could have.

    This is my quick, and hopefully accurate, summary of Scott Sumner’s views on the Great Recession. You can read more at his blog: TheMoneyIllusion.com

  4. Thanks, Tim. I had come across Sumner before but hadn’t gotten the full story on his view of the recession. So the debate seems to be over whether the banking crisis was a cause or an effect of the general downturn, which may have been a result of Fed policy.

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