SeekerBlog

The Economic Crisis

The global financial crisis of fall 2008 was unexpected. A few people had been predicting that serious problems were looming, and even fewer had placed bets accordingly, but even they were astounded by what happened in mid-September.

What did happen? There are many layers to unpeel, but let me begin with the three main events that triggered the severe global phase of the crisis. (See http://BaselineScenario.com for more on what came before, how events unfolded during fall 2008, and where matters now stand).

1. On the weekend of September 13-14, 2008, the U.S. government declined to bailout Lehman. The firm subsequently failed, i.e., did not open for business on Monday, September 15. Creditors suffered major losses, and these had a particularly negative effect on the markets given that through the end of the previous week the Federal Reserve had been encouraging people to continue to do business with Lehman.

2. On Tuesday, September 16, the government agreed to provide an emergency loan to the major insurance company, AIG. This loan was structured so as to become the company’s most senior debt and, in this fashion, implied losses for AIG’s previously senior creditors; the value of their investments in this AAA bastion of capitalism dropped 40% overnight.

3. By Wednesday, September 17, it was clear that the world’s financial markets – not just the US markets, but particularly US money market funds – were in cardiac arrest. The Secretary of the Treasury immediately approached Congress for an emergency budgetary appropriation of $700bn (about 5% of GDP), to be used to buy up distressed assets and thus relieve pressure on the financial system. A rancorous political debate ensued, culminating in the passing of the so-called Troubled Asset Relief Program (TARP), but the financial and economic situation continued to deteriorate both in the US and around the world.



Thus began a financial and economic crisis of the first order, on a magnitude not seen at least since the 1930s and – arguably – with the potential to become bigger than anything seen in the 200 years of modern capitalism. We do not yet know if the economic consequences are “merely” a severe recession or if there will be a prolonged global slump or worse.

The Crisis in Economics

Does this economic crisis constitute or imply a crisis for economics? There are obviously two answers to this question: no, and yes.

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The mainstream answer to this question is: no, because we’ve learned a lot about economics since the Great Depression and because we also learned a great deal about policy both during and after the 1930s.

I’m not so convinced. For example we know that a key policy mistake in the early 1930s was to allow banks to fail. This will not happen again, at least not for “systemic institutions” – as the G7 made clear in October. But bank failure was a problem because it contributed to a big contraction in credit – this has been well established in the work of Ben Bernanke and others. Unfortunately, we know relatively little about how to stop today’s process of falling credit around the world, known as “global deleveraging.”



…Probably existing macroeconomic thinking can accommodate this kind of analysis. It’s a blend of financial market analysis with political economy. But I don’t know any models, let alone much empirical work, that bears directly on – or comes close to testing – any dimensions of this issue. Economics is in thin air.