The collapse of the housing bubble was certainly a primary cause of the Great Recession. The unwinding of the bubble (1) depressed aggregate demand through its adverse effects on consumer wealth and residential construction, and (2) triggered a financial panic, including runs on wholesale funding and indiscriminate fire sales of even non-mortgage credit. I have argued that the panic, which choked off credit supply and stoked uncertainty and risk aversion, was the more important of these two channels of effect on the real economy. Paul Krugman has argued the opposite; he says that while the financial panic may have made the descent into recession steeper, the overall depth of the recession would have been more or less the same if there had been no panic (See below for relevant links.)
The key evidence for the panic having had a central role in the severity of the recession is timing. The recession got much worse when the crisis escalated in the fall of 2008, and the recovery began shortly after the panic was contained in the spring. Paul acknowledges the timing but says that the recession would ultimately have gotten as bad, just less quickly if not for the panic. Here I offer a few comments in response. See my paper and blog posts for details.
(1) It’s not obvious that restoring equilibrium in the housing market required a recession as large as we saw. Indeed, for the first two years of the housing bust, starting in early 2006, house prices and construction fell significantly without much evident damage to aggregate output. A more gradual unwind of housing prices and construction might have been better absorbed by the economy and by the policy response. In particular, if the panic had not accelerated the downturn, the Fed might not have faced the zero lower bound on interest rates so early or for so long.
(2) On the magnitude of the effects, in August 2008 the Fed staff did “worst-case” forecasts that assumed house prices would fall by as much (it turned out) as they actually did. These conditional forecasts incorporated the best available estimates of wealth effects, impacts of changes in residential construction, etc., yet they radically underestimated the level of unemployment that would actually occur. So the direct effects of the housing bust appear quantitatively too small based on the best available models.
(3) The international recession was deep and highly synchronized. Trade collapsed. It’s hard to see that as the result only of a U.S. housing bust. Given the global nature of finance, it’s easy to explain in terms of panic.
(4) It’s true, as Paul emphasizes, that even though the panic was over by 2009 the recovery was slow. Financial stress on the part of homeowners certainly explains some of that. But, as Paul has noted, other factors delayed recovery, including the zero lower bound on interest rates, an attenuated fiscal response, and slow adjustment of wages. These factors are relevant whatever the source of the recession. Krugman in recent writings has also emphasized hysteresis effects on productivity growth. A panic-induced credit crunch could have had such effects by affecting business startups, venture capital, R and D spending, and capital investment.
Paul and I agree that stopping the panic was important to avoid risking further damage to the economy. We do disagree on how much of the damage that actually did occur was the result of the panic.
What do readers think?
Krugman original post: https://www.nytimes.com/2018/09/12/opinion/botching-the-great-recession.html
Bernanke BPEA paper: https://www.brookings.edu/wp-content/uploads/2018/09/BPEA_Fall2018_The-real-effects-of-the-financial-crisis.pdf
Krugman response to Bernanke’s BPEA paper: https://www.nytimes.com/2018/09/14/opinion/the-credit-crunch-and-the-great-recession-wonkish.html
Bernanke response to Krugman: https://www.brookings.edu/blog/ben-bernanke/2018/09/21/the-housing-bubble-the-credit-crunch-and-the-great-recession-reply-to-paul-krugman/
Krugman’s response to Bernanke’s response: https://www.nytimes.com/2018/09/22/opinion/steeper-versus-deeper-wonkish.html
Krugman post on hysteresis: https://www.nytimes.com/2018/09/30/opinion/the-economic-future-isnt-what-it-used-to-be-wonkish.html