An alternative explanation for the Great Recession

An Alternative Explanation for the Great Recession

The standard view of the Great Recession is roughly as follows:

1. There was a severe financial crisis caused by reckless subprime lending.
2. The Great Recession followed.
3. The financial crisis caused the Great Recession
4. Monetary policy was quite stimulative, but failed to prevent a sharp fall in GDP.
5. The recovery has been slow, because severe financial crises are generally followed by weak recoveries.

I will show that there is a highly plausible alternative explanation, which is entirely consistent with the stylized facts.  The alternative scenario is roughly as follows:

1. The subprime crisis created financial distress during 2007 and early 2008.  The estimated losses were not large enough to cause a severe banking crisis, or a severe recession.  As late as mid-2008 most experts expected growth in 2009, with little change in unemployment.
2. Monthly nominal GDP estimates by Macroeconomics Advisors show that after June 2008 nominal GDP fell sharply for six months, and then leveled off after December 2008.  Real GDP followed a similar pattern.
3. The fall in nominal and real GDP between June and December 2008 sharply reduced asset values and greatly intensified the debt crisis in the fall of 2008.  Just as in the Great Depression, falling NGDP caused banking distress.  During 2008-09, NGDP saw its largest decline since 1937-38.  Even without the subprime crisis, this would have caused significant banking distress.  As it was, it tipped an already fragile banking system into a major crisis. 
4. The Fed took no effective steps to address the fall in NGDP after June 2008.  They refused to cut rates after Lehman failed in mid-September, and the subsequent injections of base money were sterilized by an interest-on-reserves program.
5. Most economists assumed money was “easy,” because nominal rates were relatively low and the base increased dramatically.  This was also true in the Great Depression, only later did economists recognize that money was actually tight in the 1930s, despite low rates and a soaring monetary base.
6. Almost all asset markets signaled extraordinary tight money in late 2008.  Housing prices began falling in regions unaffected by the 2006-08 subprime fiasco, such as Texas.  Commercial real estate price began plunging in late 2008, after doing well during the initial subprime crash.  Commodity prices fell by more than 50%.  Stock markets crashed.  Inflation expectations (from TIPS spreads) plunged into negative territory.  The dollar appreciated rapidly against the euro between July and December 2008.  And real interest rates on 5 year TIPS soared from 0.57% in July to over 4% by late November 2008.  All indications of tight money.

The recovery has not been slow because of the financial crisis, but rather a lack of aggregate demand.  Real growth averaged only about 2.8% during the first six quarters of recovery, roughly the trend rate of growth.  It’s no surprise that job creation has been anemic.  And the slow RGDP growth can be easily explained by the 3.9% growth in NGDP.