Modern Macro Got the 2008 Crisis Painfully Wrong

By William K. Black

December 19, 2017     Bloomington, MN

Lawrence J. Christiano was the lead author of the article announcing the Dilettante doctrine that I discussed in the first column in this series.  His ‘dilettante article’ claimed that modern macro got the last crisis so wrong because it ignored the ‘shadow’ financial sector.  I have found a 2008 article by him and two Minneapolis Fed co-authors that illustrates modern macro’s blindness to the shadow financial sector.  The article is entitled “Facts and Myths about the Financial Crisis of 2008” and the first footnote says that they wrote the article based on information available on October 25, 2008.  The purpose of the article was to demand that proponents of fiscal and monetary stimulus prove a specific “market failure” justifying stimulus.  Christiano and his co-authors agree that the Nation is in a “financial crisis” and that it could lead to a serious recession, but see no reason for the government to act.

To review the bidding, at the time the modern macro devotees were calling on the government not to act,  Bear Stearns, IndyMac, Lehman, AIG, Fannie, Freddie, Merrill Lynch, Wachovia, and Washington Mutual had failed or been bailed out or acquired.  Several hundred mortgage-banking firms had failed.  Every money market mutual fund had suffered a massive run (the largest in world history) that was broken only by massive federal aid and guarantees.  Housing prices were in free fall.  CDOs were experiencing astonishing credit rating downgrades.  The leading credit firms of GE and the automobile companies were insolvent, unprofitable, and desperate for bailouts.  The remaining two major investment banking firms were converting to bank holding companies on an emergency basis so that they could borrow from the Fed.

By late October 2008, every macroeconomist would have been aware of these facts and focused on how they were causing the financial crisis to metastasize at an appalling rate.  Christiano and his co-authors at the Minneapolis Fed and U. Minnesota, however, did not even use the word “shadow” financial sector in their article.  They warned against stimulus:  “Indeed, many economic theories implies [sic] that such massive intervention will likely do more harm than good.”

[I]t is incumbent on policy-makes [sic] to provide hard evidence that good borrowers with relatively safe projects are unable to get credit because of the increased cost of intermediation due to a breakdown in the system of .financial intermediation,

No, that is nonsensical.  Recessions like the Great Recession are about insufficient demand leading to severe unemployment and underemployment.  The problem was not that lenders were refusing to lend money to manufacturers to build new plants.  The problem was that manufacturers rightly believed that demand for their products was falling sharply.  The manufacturers did not want to borrow and increase production capacity in such circumstances.  American households believed they had excessive debt and were cutting consumption to repay debt, creating a classic “paradox of thrift.”  These are the classic, sensible grounds for government fiscal stimulus.  If Christiano’s advice had become policy the results could have been catastrophic.

Christiano’s claim that there was no apparent “market failure” by the end of October 2008 was bizarre.  First, there was a massive market failure because the largest bubble in history arose in the United States (and the contemporaneous real estate bubbles in Ireland and Spain were, proportionately, even larger).  Second, there were legions of market failures producing the epidemics of ‘accounting control fraud’ that drove the financial crisis in the U.S. and other nations.  These market failures involved failures in many markets.  The real estate bubble, for example, revealed market failures in appraisals, underwriters, loan brokers, compliance, auditing, law, credit rating, due diligence, securities, CDOs, and CDS.

Christiano claimed that the stock markets reacted adversely to the adoption of fiscal stimulus.

[V]arious stock markets have fallen dramatically, especially in the week after the bailout plan was passed.

That claim was disingenuous.  The House of Representative’s rejection of the ‘bailout plan’ on September 29, 2008 caused first a national and then a global collapse in stock market prices.  The plan’s adoption on October 3, 2008 led to a powerful, positive effect on bank stock prices.  It is true that after TARP’s passage, the global economic news continued to get far worse and stock prices fell substantially, but no one attributes that to TARP.

Fortunately, Christiano’s piece appears to have produced the unintended consequence of convincing the Narayana Kocherlakota, when he stepped down as Chair of U. Minnesota’s economics department to become President of the Minneapolis Fed, that the incestuous relationship between the Fed and the department had produced a harmful degree of inbred macro dogma.  Freshwater macro devotees went berserk in their criticism of Kocherlakota when he diversified the Minneapolis Fed’s macroeconomic scholars’ views.