Thursday, 4 August 2011

A semantic dispute about the reasons behind the financial crisis?

Steve Randy Waldman provides a convincing explanation of how bank and sovereign behaviour interacted to cause the financial crisis. But he seems to be writing this as a critique of Tyler Cowan's theory that the crisis was caused by the “we thought we were wealthier than we were” mechanism. I think perhaps this could be resolved simply by accepting that Waldman's story is what lead to aggregate behaviour that was equivalent to "us" (or to our "representative agent") behaving as if we thought we were wealthier than we actually were. See also Chris Dillow .

My view is that there was a lot of (effective) "we thought we were wealthier than we were" behaviour over the 00's - for whatever reason. This imagined wealth increase lead to households making a portfolio rebalancing decision to lever up against this higher value for our assets (houses), and so to collectively borrow to consume. The financial crisis was caused when commodity supply constraints (a small supply shock) lead to price pressures (eventually $140 oil) which lead to an effective re-evaluation of our wealth and a consequent massive retrenchment (large demand shock). The appropriate policy now is Keynesian demand creation, as per Krugman, to maintain employment and allow households to repair their balance sheets. This provides a tremendous opportunity for public direction of investment whilst the state is taking up the slack and it should be 100% piled into energy investments since that relatively small supply constraint is only going to grow.

Austerity is completely the wrong response.

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