Sunday, September 20, 2009
Was It Actually a Monetary Crisis?
In the first post in a debate on Cato Unbound, Scott Sumner argues that contrary to the general consensus of the papers in Critical Review, the crisis was indeed "macro"--caused by contractionary monetary policy in the summer and fall of 2008--rather than being a "financial" crisis caused by banks' misinvestments in mortgage-backed securities.
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It was both.
The banks, especially the investment banks, lent into a speculative bubble in housing.
The loss of confidence in the shadow banks resulted in an increase in the demand to hold money--especially FDIC insured deposits.
The Fed failed to increase the quantity of money enough to accomodate this increase in money demand. And so, nominal income fell.
Sumner insists that it was when "the market" figured out that the Fed wasn't going to increase the quantity of money enough to offset the increase in demand, the expectation of falling expenditure caused the demand for money to rise tremendously, and so that was why nominal expenditure dropped so much between October 2008 and March 2009.
If the Fed had kept nominal income growing on target, investment banks especially, would still have been insolvent because they lent into the speculative bubble in housing. Commercial banks were less exposed, but many of them may have failed too. However, they wouldn't face further losses from loans made bad because of falling nominal expenditures and employment.
Excess capacity in housing created by the speculative bubble would still imply reduced productive capacity in aggregate. Higher structural unemployment would similarly imply lower real output. With nominal income targetting, slower real income growth and higher inflation would be the necessary result.
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