The cause of the Great Recession: In pursuit of an alternative explanation

According to conventional wisdom, the economic crisis that began in 2008 was a financial crisis, caused by irresponsible lending and large credit defaults. This paper questions this explanation of how the crisis began, suggesting instead that the crisis was caused by structural budget deficits. In a non-technical analysis based on the Brunner-Meltzer relative-price model, this paper suggests in three steps that the welfare state, not financial institutions, was the main cause of the crisis. 

• In the first step, government borrowing prior to the crisis had taken on structural proportions. Sustained government borrowing weakened or eliminated market-based signals that otherwise would have prevented financial institutions from excessive risk taking.
• In the second step, financial institutions are kept liquid by central banks. At the same time, governments with excessive debt see their credit rating tumble. Using low-cost credit from central banks, financial institutions purchase higher-risk government debt, a move that adds to their portfolio imbalances. The Greek debt write-down underscores the increased risk taken by already troubled financial institutions.
• In the third step, the EU, the IMF and the ECB create austerity programs for troubled welfare states. These programs, intended to improve government budgets and reduce the financial and fiscal cost of the welfare state, temporarily succeed in improving government budgets. However, the price is high in terms of slow or negative growth and a protracted macroeconomic crisis.

In conclusion, by suggesting that the crisis was caused by financial institutions, legislators in both Europe and North America fail to address the root cause of the crisis. As a result, the mechanisms that caused the crisis remain in place and continue to cause macroeconomic ailment, keeping the European economy from recovering.