One Interpretation of Recession Causes… with Really Long and Really Variable Lags

In an Economix post today, titled “The Panic of ’08: Recession Cause or Effect?” Professor Mulligan writes:

…recent research questions the claim that the financial panics themselves contributed to their contemporaneous and severe employment downturns.

The post continues:

The timing was different in this recession — the largest employment drops seemed to come immediately after the financial panic — but a recent paper by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg of Northwestern argues that the coincidence is just as misleading. They argue that the changing global economy — with more employment of residents in developing countries like China — created a glut of savings in those countries, and was destined to reduce employment in developed countries regardless of whether there had been a financial panic.

This paper was discussed earlier on this weblog, and Professor Jagannathan provided some clearly exposited counterarguments to my criticisms in his comments. Indeed, I think there’s a lot more subtlety to that paper, and the posited causal chain, than is related above, even if I disagree with the main thesis (see [1]).


But even if you believe the Jagannathan, Kapoor, Schaumberg thesis in full, this does not invalidate the idea that banks provide useful intermediation services, and that failing banks, insolvent banks, or banks that are retrenching in terms of their lending will exert a contractionary influence on the economy. (After all, if one reads Bernanke’s 1983 paper (AER 73(3)), you’ll see him focus on the declining ratio of loans to the sum of checking and savings deposits, shown in his Table 1) It’s just that you think that what caused the banks to overleverage is the “saving glut”. (Another way to put it is you think the financial system is the proximate cause, and Beijing the ultimate cause, a la “Blame it on Beijing”). This interpretation is suggested to me by this passage in the conclusion to Jagannathan et al.:

might have taken an entirely different path with better risk management controls in place
in the US but then again, financial innovation might just have found a different way of
getting highly leveraged deals done off-shore or through creative accounting. The root
cause of the excess liquidity in the global financial system must be addressed, otherwise we
are just squeezing the proverbial balloon only to see it bulge out somewhere else. However,
this does not negate the need for the development of improved risk management in the
broadest sense in order to ensure financial stability and prosperity going forward.

One truly odd aspect of Professor Mulligan’s discussion is the treatment of the banking system as the financial system. I’ve been hearing a lot about the “shadow financial system” for quite a while — and I have some inkling there was trouble brewing there somewhat before the plunge in employment and output in September 2008. Below, I graph one aspect of the broader financial system.

Figure 1: Commercial paper outstandings, in billions of dollars, seasonally adjusted. Source: Federal Reserve Board, data releases, commercial paper.

So in my view, the financial system problems preceded the initial decline in employment and output. That doesn’t preclude the possibility of the subsequent declines in employment and output causing further financial system problems. That I believe is what is called an adverse feedback loop.


More graphs from the real world in this post and the IMF’s GFSR.


Postscript: Brad Delong also appears to find this post befuddling.

13 thoughts on “One Interpretation of Recession Causes… with Really Long and Really Variable Lags

  1. ppcm

    Agree with your conclusion
    The general public and administrations are lending too much intelligence to the banks when they are merely the bookeepers of the economies.
    At contrario when proved to have failed to read accurately their economies they are deemed afterwards to be restristictive.
    Once the banking industry is broken between casino banks always busy borrowing at zero interest rate purchasing papers to be hedged and flipped and making business with each others,and the genuine lenders meeting with hurdles worsening solvencies (private,corporates) existing and future.
    Banks do not produce the unemployment, the real industries are the main providers of recovery and the real core of economies.Banks are laggard indicators when trying to foretell recoveries.
    National Bureau
    of Economic Research
    APRIL 18, 1934
    Recent Corporate Profits in the United States
    Copyright 1934, National Bureau of Economic Re.rcarch, Inc.
    How about testing above by setting up a government owned bank,there is enough TARP money flowing back?

  2. Steve Kopits

    Yes, the financial crisis had its roots in the volatility of July/Aug 07; employment started dropping around Jan. 08. China appears to be the most likely source of the excess liquidity which permitted the financial crisis. An interesting question is whether the undervalued yuan led to the excess liquidity, ie, China blew up the global economy by trying to maintain an export led growth model when the size of the exporter–China–was ultimately ‘large’ compared to the importer–the US, such that the US was unable to safely absorb the quantity of exports foisted on it by the China. In other words, China is now too big to use an export-led growth model of the sort used by Korea or Japan.
    As for financial crises and jobs: To me, the impact of the failure of Lehman on employment was truly stunning. It suggests to me why the failure of financial institutions in the Great Depression led to such high unemployment. A recession can be viewed as a large scale, involuntary re-assignment of property rights. That’s what bankruptcy and foreclosure are all about.
    Such a re-assignment involves i) time lags, ii) uncertainty about outcomes (who will own how much in the end); and iii) changes in demand due to differing tastes between the defaulting and foreclosing owners. So, when a company enters Chapter 11, the incumbent owners no longer have a direct stake in the company, but the new owners–the creditors–do not yet have control over the company. In this interim, companies in Chapter 11 often find it difficult to enter into contracts and often lose customers and lay off employees.
    Further, a new owner may have different views of a business. For example, Bloomberg’s purchase of Business Week will almost surely imply radical changes in the latter’s organization, including layoffs and consolidation.
    Therefore, during the period of re-assignment of property rights, the resulting uncertainty will lead to lay offs as consumers and businesses hunker down until visibility returns.
    These property rights repose, in large part, in the banks and other financial institutions. When banks fail, their property rights are put into play, and this leads to a recession and lay offs. By this thinking, it is not primarly the failure of Lehman which caused the crisis, but the failure of the property rights of Lehman’s counter-parties which caused the crisis. So, the failure of large financial institutions are very damaging because they are repositories of property rights. (Put another way, had Lehman been unwound rather than sent into Chapter 7, much of the pain could have been avoided.)
    Consequently, it would appear that protecting financial institutions from collapse (but not necessarily an orderly winding up) may be a critical factor in preventing large scale unemployment. In 2008, the Fed acted to stop the rot; in the Great Depression, it did not. By implication, had the government allowed GS, BoA, ML, AIG and other large institutions to fail, the level of employment would be dramatically higher than today, with clear parallels to the Great Depression.
    This is my sense of it, but I can’t claim to have thought it through entirely. On the other hand, it should be relatively straight-forward to test this notion empircally. Perhaps a task for a graduate economics student looking for a thesis.

  3. michelle color me shocked

    Doesn’t Professor Mulligan also believe that the increase in unemployment was voluntary? So which was it that removes any responsibility for the US to reform its broken financial system: the Chinese or the US workers wanting a holiday and a mortgage bailout?
    I wouldn’t mind Prof Mulligan making this argument, since he is basically the anti-indicator of truth, but “blame China” is becoming a refrain at the Fed as well. Never mind that certain other countries with current account deficits (Australia, NZ and believe it or not, Spain), did *NOT* blow up their banking systems over this period.

  4. ISLM

    Don’t forget: this crowd believes the problems began in the regulated (ie, depository) side of banking. (This point is made in Cochrane’s response to the Krugman NYT Magazine piece.) When one starts with a false premise, the result is usually ridiculous.

  5. DM

    Subprime mortgage banks (New Century, FIL, etc.) started closing their doors around mid-2007 if my memory serves (I worked in the mortgage banking space then) because of the first wave of defaults and the fact that they had to buyback loans they wanted nothing to do with. Question though: what was the cause of the first round of defaults? I would assume people couldn’t continue to make payments because they started losing their jobs.

  6. Kien Choong

    It seems hard to disentangle one’s diagnosis of the economic crisis from one’s beliefs and values. A believer in free markets and government failure will tend to attribute the “ultimate cause” to the Chinese government’s intervention in the foreign exchange market. On the other hand, someone that regards building up foreign reserves as a legitimate, rational response to imperfections in the international capital market will tend to attribute the “ultimate cause” to the imperfections of the financial system. A person’s beliefs and values determines what that person thinks can be changed, and what can’t be changed, and cause is attributed to the things that one believes can be changed.

  7. Anonymous

    It’s a bit heart breaking to see some leading economist come up with such bogus arguments all to defend personal political believes. It seems that good economics comes in at a distant second place. But that wouldn’t be so bad. What’s truly outrageous is that common sense comes in third.

  8. Hitchhiker

    I spent a little time in the mortgage industry also. The job losses came later after the financial crisis. However, the oil price shock can explain people unable to pay mortgages especially if they were on houses relatively far from work. Also, the adjustment of ARM mortgages put payments out of reach for many that were told when they went into them, don’t worry about that, we will refinance it before that happens. I heard this a lot. Btw, the only mortgages I did in my short stint were fixed rate loans at historically low rates.
    Imo, the whole mess was caused by pump prices for gasoline. The mere threat of recession punctured the financial balloon that was allowed to blow up to ridiculous heights. Mark to market ensured a fast meltdown before the other effects of recession became pronounced.

  9. Arthur

    ‘Really long’ would try to take account of the entire postwar period with its long expansionary phase on one hand and the contrary which developed as accumulation transformed into over-accumulation and falling rate [s/v+c] of profit, recognizing greater transnationalization of production and distribution + financialization + ‘permanent crisis management’ to be logical resultants of/reactions to the post-1969-73 entrance into a certainly not linear but real long slowing.
    transcyclicality is too often ignored.

  10. Peter Van Schaik

    I think too many intelligent people are over thinking the problem when trying to pinpoint the primary motivator in the current or, in reality, any, recession. The primary cause just isn’t all that complicated. On January 12, 2008, when a possible recession was still being debated by the experts and the S&P had closed the day before at 1,401.02, I posted the following on The Big Picture website:
    “We are still calling for a recession of a minimum of two years. We’ve lived the high life too long without a true day of reckoning. The time has come. We can blame $100 oil, federal deficits, or the moon. It doesn’t matter. The recession became an eventual fact two years ago- for details see our April 2007 post at
    We will remain bearish until the S&P 500 bottoms below 600.
    Posted by: J. Peter Van Schaik | Jan 12, 2008 1:44:32 AM”
    I don’t possess a crystal ball. In fact I goofed: the S&P bottomed at 666.79 on March 6, 2009.
    Sometimes it pays to keep it simple.

  11. don

    “So in my view, the financial system problems preceded the initial decline in employment and output.”
    But the financial system problems were inevitable given the growth in real saving, which had to have a counterpart in real borrowing. A good part of BB’s savings glut was artificially created by currency policies in Asia (if China buys foreign exchange and prevents an offsetting private capital inflow, it forces savings on the ROW, just like when you stuff a goose to make pate de foie gras – the analogy is apt, as it shows that overeating is not always the fault of the eater) though part also came from the inability of oil exporters to immediately absorb a windfall.
    We had a similar episode when oil exporters were unable to absorb the windfalls prior to 1980 – in that case U.S. banks intermediated the excess saving to LDC’s, which were allowed to borrow at effectively negative real interest rates. Wth such incentives, it is no wonder they overdid things and we were led to the LDC debt crisis.
    The simultaneous housing booms in a number of countries and the over-done lending to eastern Europe point to a problem larger in scope than U.S. banking sector shenanigans.

  12. KevinM

    (10,000 miles per year)/(20 miles per gallon) = (500 gallons)
    (500 gallons)*(expensive $4 gas – cheap $2 gas) =($1000)
    “Real median household income in the United States climbed 1.3 percent between 2006 and 2007, reaching $50,233, according to a report released today by the U.S. Census Bureau. ”
    ($1000)/($50,000) = (2 percent)
    You are attributing the recession to a six month long 2 percent increase in expenses.

  13. AndyR

    Oil prices pushed the tide over. Overvaluation of real estate, sub prime mortgages which had the original 4-6 year ARMS came due (this happened back in 2001/2002 as well but many mortgages where refin.), bust in the housing market. I would say all of these pushed the situation to the breaking point.

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