The Great Recession & the Great Depression

Peter Temin in Daedalus:

The Great Depression and the Great Recession were both caused by policies derived from nostalgia for the world of the Enlightenment. Drawing on theories from the eighteenth century, hard-headed policy-makers either assumed or tried to re-create the idealized conditions described by Hume and Smith. These policy-makers ignored both the growth of economies of scale in modern economies and the work of behavioral economists that has shown that people do not behave as homo economicas. Their efforts produced the new economy of the 19205 and the Goldilocks economy of recent decades that turned into booms and busts. Was it inevitable that these economic expansions would end badly? According to the late economist Hyman Minsky, people become more complacent with prosperity and more willing to take on risks they often know are highly suspect.6 More recently, economists Carmen Reinhart and Kenneth Rogoff analyzed historical evidence and reached a similar conclusion : booms typically precede financial crises, just as pride goes before a fall.

More formally, people in both expansions miscalculated the risks they faced. Their models were based on shocks to individual countries or homeowners and did not allow for collective actions. The gold standard model explained how to deal with a shock to an individual country, implicitly assuming that other countries would be immune to whatever disturbance affected the distressed country. The interaction between the country in crisis and other countries would lead back to stability; a collective shock to many economies was not considered. Similarly, the model behind the Washington Consensus considered individual risks. Structured financial obligations were valued as if the underlying risk of mortgage foreclosure was the result of random and independent shocks to individual homeowners. As with the gold standard, no consideration was given to collective shocks; housing prices were expected to rise continually. It was assumed that homeowners experienced financial difficulty and defaulted on their mortgages randomly. The randomness of defaults enabled financial designers to reduce the risk to any security by diversification, that is, combining many mortgages the same way a bank combines many bank deposits. When the housing boom ended and housing prices fell, however, many homeowners began to default, and the risk that was supposed to be protected for through diversification was now present in securities previously thought to be risk free. Investors could not discern safer assets from those more at risk, and the prices of all structured finance fell. Prices of some securities fell rapidly because there were no buyers for them. Financial markets froze in September 2008.