The

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The Great Recession Economic Crisis Crisis
in Economics Sasan Fayazmanesh October 11, 2012
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Summary This presentation deals with the US
economic crisis that began in 2008, as well as
the crisis in economic theory. It is argued
that while the recent crisis was not a depression
and hardly comparable to the Great Depression, it
was a Great Recession. Moreover, the Great
Recession brought to the fore the underlying
crisis in economics.
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See Paul Krguman, End This Depression Now! 2012
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• In particular, I will look at
• The rate of growth of GDP, unemployment rate and
  bank failures since the beginning of the crisis
• The timeline of the crisis
• The problem of causation and economic theory
• But before all this

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Economics 101
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• Q What is the difference between a recession and
  a depression?

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GDP
Recession (2 quarters decline in GDP)
Historical Time
Business Cycle (Trade Cycle)
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GDP
Depression! (A severe recession)
Historical Time
Long Waves (Kondratiev waves)?
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The Great Depression (1929-1939) By 1933   1)
There was no new investment 2) GDP was down by
1/3 3) Unemployment was at 24 4) Nominal wages
and prices were down by 1/3 5) The banking
system collapsed, after nearly 11,000 banks
closed in the US (40 of all banks) 6) Stocks
lost 90 of their values
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Q1 Was the downturn in 2008 the beginning of a
depression? Q2 Are we currently in a recession?

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Year Nominal GDP (B)
Real GDP (B)
2007q4 14,253.2 13,326.0
2008q1 14,273.9 13,266.8
2008q2 14,415.5 13,310.5
2008q3 14,395.1 13,186.9
2008q4 14,081.7 12,883.5
2009q1 13,893.7 12,663.2
2009q2 13,854.1 12,641.3
2009q3 13,920.5 12,694.5
2009q4 14,087.4 12,813.5
2010q1 14,277.9 12,937.7
2010q2 14,467.8 13,058.5
2010q3 14,605.5 13,139.6
2010q4 14,755.0 13,216.1
2011q1 14,867.8 13,227.9
2011q2 15,012.8 13,271.8
2011q3 15,176.1 13,331.6
2011q4 15,319.4 13,429.0
2012q1 15,467.8 13,491.4
5.1
Source US Department of Commerce
http//www.bea.gov/national/index.htmgdp
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Unemployment Rate
Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
2005 5.3 5.4 5.2 5.2 5.1 5 5 4.9 5 5 5 4.9 5.1
2006 4.7 4.8 4.7 4.7 4.6 4.6 4.7 4.7 4.5 4.4 4.5 4.4 4.6
2007 4.6 4.5 4.4 4.5 4.4 4.6 4.7 4.6 4.7 4.7 4.7 5 4.6
2008 5 4.9 5.1 5 5.4 5.6 5.8 6.1 6.1 6.5 6.8 7.3 5.8
2009 7.8 8.3 8.7 8.9 9.4 9.5 9.5 9.6 9.8 10 9.9 9.9 9.3
2010 9.7 9.8 9.8 9.9 9.6 9.4 9.5 9.6 9.5 9.5 9.8 9.4 9.6
2011 9.1 9 8.9 9 9 9.1 9.1 9.1 9 8.9 8.7 8.5 8.9
2012 8.3 8.3 8.2 8.1 8.2 8.2 8.3  8.1  7.8        8.2
Source US Department of Labor
http//data.bls.gov/timeseries/LNS14000000
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Unemployment Rates in the 1980s Recession
Year
1979 5.8
1980 7.1
1981 7.6
1982 9.7
1983 9.6
1984 7.5
1985 7.2
1986 7.0
Source US Department of Labor
http//www.bls.gov/cps/prev_yrs.htm
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Bank Failures Per Year
The average number of bank failures in the 1930s
2000/year
2006 0
2007 3
2008 25
2009 140
2010 157
2011 92
2012 NA
Sources FDIC http//www.fdic.gov/bank/historical
/bank/2006/index.html
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Q1 Was the downturn in 2008 the beginning of a
depression? A No! Q2 Are we currently in a
recession? A Technically, no!
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However, the 2008-09 recession was one of the
most severe recessions since the Great
Depression. It was a Great Recession!
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Q How did the Great Recession of 2008-09
start? What was the timeline?
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• Partial Timeline ( Federal Reserve Bank of St.
  Louis)
• 4th quarter of 2007 Downturn in GDP (according
  to National Bureau of Economic Research, the
  recession began in December of 2007)
• January 221, 2008 stock market downturn
• January 22 The FOMC votes to reduce its target
  for the federal funds rate 75 basis points to 3.5
  percent
• January 24 The National Association of Realtors
  announces that 2007 had the largest drop in
  existing home sales in 25 years

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• March 10 Dow Jones Industrial Average at the
  lowest level since October 2006.
• March 24 The Federal Reserve Bank of New York
  announces that it will provide term financing to
  facilitate JPMorgan Chase acquisition of bankrupt
  Bear Stearns Companies Inc.
• July 11 IndyMac Bancorp is placed into the
  receivership of the FDIC.
• July 13 The U.S. Treasury Department announces a
  temporary increase in the credit lines of Fannie
  Mae and Freddie Mac.
• July 17 Major banks and financial institutions
  that had invested heavily in mortgage backed
  securities report losses of approximately 435
  billion.

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• September 7 The Federal Housing Finance Agency
  places Fannie Mae and Freddie Mac in government
  conservatorship
• September 15 Bank of America announces its
  intent to purchase Merrill Lynch for 50 billion
• September 15 Lehman Brothers Holdings
  Incorporated files for Chapter 11 bankruptcy
  protection
• September 16 The Federal Reserve Board
  authorizes the Federal Reserve Bank of New York
  to lend up to 85 billion to the American
  International Group (AIG)
• October 3 President Bush signs the Emergency
  Economic Stabilization Act, creating a 700
  billion Troubled Assets Relief Program (TARP) to
  purchase failing bank assets
• Etc.

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• Note Such sequences of events had appeared
  before. For example
• The Rich Mans Panic of 1907
• The Great Depression of 1929-1939

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Q We know the timeline, but what caused the
crisis?
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• Some common answers
• Mortgaged backed securities, particularly those
  associated with subprime mortgages
• The housing market bubble, which was made worse
  by predatory, risky and careless lending
• Exotic financial instruments or derivatives that
  were allegedly devised by some wunderkind
  mathematician or physicist on Wall Street, e.g.,
  collateralized debt obligation and credit default
  swaps
• The events of September 11, 2001, the subsequent
  US invasion of Iraq and increase in oil prices
• Irrational exuberance in the stock market
  followed by a bear market

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• The Federal Reserves repeated reduction in the
  discount rate and fed funds rate in 2001-2003
• The wrongheadedness of the chairman of the
  Federal Reserve, Mr. Alan Greenspan, who found
  himself in a state of shocked disbelief to
  learn that the self-interest of lending
  institutions might not protect shareholders
  equity
• Deregulation of the banking industry (doing away
  with Glass-Steagall Act), particularly the
  Financial Services Modernization Act of 1999 or
  Gramm-Leach-Bliley Act
• Fraud, corruption, high salaries of CEOs,
  self-serving economists, etc. (see, for example,
  Inside Job).

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My answer While each of these explanations, or
a combination of them, might have some merit,
they are mostly after-the-fact explanations (post
hoc ergo propter hoc). We dont know what caused
the economic crisis that began in 2008 (a
perfect storm?). We still dont know what
caused the Great Depression!
To be explained under Crisis in Economic Theory
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Q Why dont we know? A Because the existing
schools of economic thought are incapable of
explaining such crisis. This holds particularly
for the neoclassical school, which is dominant
economic theory. But it also holds for other
schools, such as the Keynesian school. It even
holds for the Marxian school.
To be explained under Crisis in Economic Theory
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Crisis in Economic in Theory What Caused the
Great Depression?
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Some common answers 1) The stock market crash
in 1929, 2) The banking panics and monetary
contraction, 3) The protectionist policies
pursued by the US governmentsuch as the
Smoot-Hawley Tariff, 4) The actions of the
Federal Reserve, which allowed a decline in the
money supply partly to preserve the gold
standard.
See, for example, Great Depression, Christina
D. Romer, December 20, 2003 http//elsa.berkeley.
edu/cromer/great_depression.pdf
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All such explanations are, of course, ad hoc.
To this day there is no consensus among
economists as to what caused the severe
depression that lasted from 1929 to 1939.
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Neither contemporary forecasters nor modern
times-series analysts could have forecast the
large declines in output following the Crash of
1929. (Kathryn M. Dominguez, Ray C. Fair and
Matthew D. Shapiro, Forecasting the Depression
Harvard versus Yale, The American Economic
Review, Vol. 78, No. 4 (September, 1988), pp.
595-612.)
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The best economic brains of the 1920s, the
so-called experts, could neither foresee the
coming disaster nor predict correctly its
magnitude and duration.
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The comments of some of the experts right
before and after the stock market crash of
October 24, 1929 See, The Experts Speak
The Definitive Compendium of Authoritative
Misinformation, Christopher Cerf and Victor
Navasky, 1984
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 The well-known neoclassical economist and
monetary expert, Irving Fisher, makes the
following predictions about the stock
market   October 17, 1929 (7 days before the
crash) Stocks have reached what looks like a
permanently high plateau.   November 14, 1929
The end of the decline in the stock market
will... probably not be long.   A year after the
crash For the future, at least, the outlook is
bright.  
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Other financial experts had similar outlooks and
predictions For example, the presidential
advisor Bernard Baruch writes on   November 15,
1929 Financial storm has definitely
passed.   Chairman of the Continental Illinois
Bank of Chicago writes on   October 24, 1929
The crash is not going to have much effect on
business.    
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The World Almanac of 1929 writes   The Market
is following natural laws of economics and there
is no reason why both prosperity and the market
should not continue for years at this high level
or even higher.
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Why the existing schools of economic thought are
incapable of explaining crises?
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• The Neoclassical or Marginalist School
• This is the dominant school of economic theory
• It is a-historical theory that starts not with
  analyzing any real economy, but with certain
  concepts in mathematical physics.
• A market consists of two lines!

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A Market
p (price per unit)
Supply
pe
Demand
Quantity
Qe
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• All market are self-adjusting
• Left alone, they correct themselves and reach
  equilibrium
• Laissez faire is the name of the game.
• This holds for the labor market and capital
  market

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Labor market
W (real wage)
Supply of labor
we
Demand for labor
Quantity of labor
Le
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Capital market
i (real interest)
Supply of capital
ie
Demand for capital
Quantity of capital
Ke
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• In the neoclassical world
• Neither fiscal policy nor monetary policy can
  change the real variables.
• Deficit spending results in higher nominal
  interest rates.
• Expansionary monetary policy results in higher
  prices.
• There is actually no need for money in this
  world,
• money is a veil.

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The Keynesian School Keynes clearly saw the
incompatibility between the neoclassical theories
and the real world, particularly during the Great
Depression. He criticized certain laissez faire
aspects of these theories and ultimately
advocated for fiscal and monetary policies.
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Yet, Keynes was educated in the same neoclassical
school and his criticism of these theories was
halfhearted . A few critical notes at the
beginning of The General Theory of Employment,
Interest and Money (1936) were followed by some
theories that were incomplete, underdeveloped and
ambiguous. The result was the neoclassical
synthesis, a combination of the old-fashioned
neoclassical theories, called microeconomics, and
Keynesian theories, called macroeconomics.
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The ambiguities left in the General Theory has
also allowed for various kinds of
Keynesians. The Keynesians are at odds with
one another as to how high the deficit can go or
what steps the Federal Reserve System should
take. They disagree over such matters as how
much regulation the financial sector of the
economy needs. Yet, all Keynesians, similar to
Keynes, believe in saving capitalism from itself
reform, and not revolution, is their aim. 
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The Marxian School The Marxist economists
believe in revolution and not just reform.  For
these economists a little more or a little less
deficit spending, or tinkering with the money
supply, will not solve the long-term problems of
capitalism. Financial woes of the capitalist
economy cannot be solved by more regulation. 
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Marxian economics, following Marx, does indeed
have crises theories. In his Capital Marx had
two theories of crisis, one cyclical and another
secular. Neither of these theories, however,
can explain the Great Recession of 2008.
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In sum, none of the prevailing economic theories
provide a viable option for understanding and
dealing with the Great Recession. That is why I
am waiting for new ways of thinking and new
economic theories!