In this and a few subsequent posts, GEM analysis is used to explain the 2008-09 Great Recession. The analysis improves on the mainstream New Keynesian (NK) narrative and faulty policy advice. What follows sets the stage. The series then summarizes GEM extreme-instability modeling, originally constructed to support Federal Reserve policy deliberations during the financial crisis and exposes the inadequate labor core of NK stabilization macroeconomics. NK extreme-instability policy advice is moreover shown to be inadequate. On a more positive note, the series summarizes GEM policy advice on how to effectively manage extreme instability.
Deconstructing the crisis. The 2007-09 cyclical contraction in the United States earned its watershed status largely as a result of the Fed’s rewriting its monetary-stabilization playbook. In particular, the Fed expanded the range and scale of its financial-market interventions in order to prevent in the nominal demand disruption that developed in late 2007 and early 2008 from mutating into the virulent nonstationary demand disturbance (NDD) that was organizing itself in the second half of 2008 and into 2009. Central real shocks were, at a first approximation, the reduction in housing activity and damaged investor/lender confidence associated with the topping out of a speculative bubble centrally rooted in low interest rates, degradation of underwriting standards for residential lending, and deeply flawed securities ratings. The bubble was also critically inflated by international currency manipulations that produced huge, chronic global trade and saving imbalances and depressed longer-term dollar interest rates in an extended period leading up to the financial crisis.
Nonstandard mortgages had been reversed engineered and packaged with standard mortgages into complex collateralized debt obligations (CDOs), offering higher yields than similarly rated U.S. Treasury debt, and sold to institutional investors via extensive distribution and servicing networks, broadening the global vulnerability to U.S. subprime (and other exotic) defaults. Such defaults, once they began to occur, motivated market participants’ reassessment of the creditworthiness of highly leveraged financial firms that held large inventories of the faltering asset class.
The Lehman bankruptcy in September 2008, closely following the U.S. Treasury’s takeover of Fannie Mae and Freddie Mac and closely followed by the implosion of AIG, transformed negative reassessment into sharply increased fear of systemic credit losses, reorganizing the garden-variety recession (featuring a stationary demand disturbance) into a potential NDD. The collapse of lender/investor confidence, as market participants began assigning nontrivial likelihoods to depression, and the consequent hoarding of liquidity converted the market markdown of subprime mortgages – a manageable macro problem – into a crisis of frozen or collapsing financial markets that quickly and substantially weakened aggregate nominal demand. The contractionary damage to total spending was further amplified by a breakdown in borrower confidence, resulting in large cutbacks in loan demand by creditworthy firms and households and damaging investment and consumer durable spending.
Federal Reserve response. The Federal Reserve properly sought to stabilize, and reverse, the nominal demand contraction. However, as indicated by the NDD-characteristic collapse of mark-to-market asset prices, the Fed’s real-objective interventions lacked credibility. While agents were broadly aware of Fed goals and actions, they were insufficiently convinced that the remedial policies would be successful in the context of 2008-09 spending disruption. Huge losses that are understood to result from investing in front of depression/deflation cause even small, albeit nontrivial, probabilities of an unchecked NDD to induce rational investor inaction, preserving liquidity until credible asset-price floors are established. (See the next post in this series.) The Fed understood what was happening, properly rejected the dangerous guidance of mainstream market-centric macro thinking, and promptly undertook demand-stabilization policies of uncommon size and design.
The Fed crucially understood that the origins of financial panics matter less to the design and implementation of central-bank stabilization policy than does the nature of crisis propagation. Most significant to monetary policymakers is how financial disruption spreads via weakening total spending, including the channel through which such nominal disturbances induce involuntary job loss.
The point is important, deserving emphasis. By its nature, even the most enlightened monetary policy plays little role in the effective prevention of financial crises, an objective more properly assigned to other central-bank and regulatory-agency functions. Monetary policy, however, plays a central role in containing and reversing contracting aggregate demand that always propagates financial crises. The downward-wage-rigidity (DWR) channel through which adverse nominal disturbances damage profits and induce involuntary lost jobs critically propagated the 2008-09 financial crisis, helping to transform it into the most perilous instability since the 1930s depression.
New Keynesians
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